Nowadays, currencies seem to be hitting all-time highs and all-time lows more often than ever before. Exchange rates are constantly fluctuating, causing somewhat of a headache for frequent travellers and international businesses around the world. But why do currencies fluctuate so often? The answer is relatively simple; supply and demand. The definition of supply and demand is ‘the amount of a commodity, product, or service available and the desire of buyers for it, considered as factors regulating its price.’ Simply put, the cost of something depends on how much is available against how many people want to buy it.
The majority of the world’s currencies are bought and sold based on flexible exchange rates, meaning their prices fluctuate based on the supply and demand in the foreign exchange market. Increased demand for a particular currency or a shortage in its availability will result in a price increase. A decreased demand or an influx in supply will lower its price. The supply and demand of currency are connected to several interrelated factors, including monetary policy, inflation rates and the conditions involved with the political and economic environment. So, let’s take a look at these individually.
Through monetary policy, a country is able to stimulate its economy. Central banks attempt to control the demand for currencies by increasing or decreasing the money supply and/or benchmark interest rates. The money supply is pretty self-explanatory; this is the amount of money that is in circulation within a country. As money supply increases and the accessibility to a currency rises, the cost of borrowing money decreases. The interest rate is the price at which money can be borrowed. With low-interest rates, people are businesses are more willing and able to borrow money. With more money being borrowed and ultimately spent, the economy begins to grow. However, if the amount of money in the economy is too high and the supply of good and services do not match, prices of these goods and services may begin to inflate.
Another factor which has a huge bearing on the fluctuations of currencies is the rate of inflation. The inflation rate is defined as ‘the rate at which the general price of goods and services is increasing.’ A small amount of inflation generally indicates good economic growth, however, too much of an increase can cause the economy to become unstable, leading to depreciation and decline in value of a currency.
The interest and inflation rates of a country have a huge influence on a country’s economy. If the inflation rate gets too high, the central bank may counteract the issue by increasing interest rates. The encourages people to stop spending and save their money instead as well as stimulating foreign investment and increasing the amount of capital entering the marketplace, which results in an increased demand for a currency. Therefore, an increase in interest rates can lead to an increase in the value of a currency. Similarly, a decrease in interest rates can result in a reduction in the value of a currency.
The Political and Economic Environment
The political and economic environment of a country is the final factor that can impact fluctuations of currency. Despite investors enjoy high interest rates, they also appreciate the predictability of an investment. This is why currencies from countries that are politically stable and have a solid economy tend to have a higher demand, which results in higher exchange rates.
Markets are constantly monitoring the current and predicted economic conditions of a country. As well as money supply, interest and inflation rates, other key economic indicators such as GDP, housing, unemployment rates and trade all have an influence on the economy of a country. If these factors show a strong and growing economy, its currency will tend to rise in value as demand increases.
Political conditions also have a resounding impact on the value of a currency. If a country is in the middle of political unrest or global tensions, take Brexit for example, the currencies of that country become less attractive and demand falls. On the other hand, if a market sees the introduction of a new government that shows signs of strong economic growth, a value of the currency may grow as people begin to buy based on the good news. It can be confusing though. Many would assume that the recent resignation of Sajid Javid as Chancellor would have negatively affected the pound. A key figure and supposed close ally of the Prime Minister would surely show the world that the UK is in yet more chaos and would affect confidence. However, the pound was given a boost by this, as the expected result is that Boris Johnson will have more control over spending, and the indications is that the budget will show higher spending than previous years.
In the end, there is not one single factor that can answer the question ‘why do currencies fluctuate?’ Instead, a host of factors related to demand and supply affect the values of currency and with more knowledge regarding these factors and their implications for fluctuations, the more accurate the predictions of value become.