Why do Currencies Fluctuate?

Exchange rates

Exchange rates specify how much one currency is worth compared to another. For example, an exchange rate of 1.19 Euros to the pound means that each £1 you have will be worth €1.19 when you go to Europe.

A huge amount of money is exchanged every day - by some estimates, about $3.2 trillion worth of currency changes hands every day.

In addition to the official exchange rate, you might find that you're charged commission when you want to change some currency, or that you’re quoted a less favourable rate. This is because exchange bureaus want to make a profit on their dealings.

Supply and demand

A market-based exchange rate will change whenever the value of currencies change. A currency will usually become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply.

This does not mean that people no longer want money; it just means that they prefer to hold their wealth in some other form, possibly another currency. Increased demand for a currency is due to either an increased ‘transaction demand’ for money, or an increased ‘speculative demand’ for money.

The transaction demand for money is related to the country’s level of business activity, gross domestic product and employment levels. For example, the more people that are out of work, the less the public as a whole will spend on goods and services, resulting in a drop in the value of a currency.

Central banks, such as the Bank of England or the USA’s Federal Reserve, will adjust the supply of money to accommodate changes in demand due to business transactions.

The speculative demand for money is much harder for a central bank to accommodate, but it will try to do this by adjusting interest rates. Investors will choose to buy a currency if the return - or interest rate - is high enough. The higher a country's interest rates, the greater the demand for that currency.

In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. Most people will not be interested in a currency if they think it will devalue. A currency will tend to lose value, relative to other currencies, if the country's level of inflation is high, if the country's level of output is expected to decline, or if a country is troubled by political uncertainty.

Black Wednesday

The most famous example in British history was Black Wednesday - when the pound fell out of the European Exchange Rate Mechanism (ERM) on 16 September 1992, after speculation led to downward pressure on the pound. The ERM was a system by which the value of the pound relative to other European Union currencies was not supposed to fluctuate by more than 6%.

To keep the value of the pound within this level, the then Chancellor, Norman Lamont - who had control of the Bank of England - raised interest rates from 10% to 15% in one day and spent billions buying pounds to try to fight off the speculators. But by the end of the day, the government had to admit defeat in the face of the speculators, and the pound fell in value and out of the ERM.

Some analysts believe that the housing market crash of the early 1990s and the Conservative government’s reputation for fiscal prudence were direct consequences of the ERM crisis.

That the following Chancellor and future Prime Minister, Gordon Brown, subsequently made the Bank of England independent and free to set its own interest rates, is also a consequence of Black Wednesday.

Getting the best deal on your currency

Although you can’t always predict how exchange rates will fluctuate, there are things that you can do to improve your holiday money exchange rate. Many money changers now offer commission-free exchanges and shopping around for the best deal can save you money.

You can also buy your foreign currency online, which will usually get you an even better deal on your cash.

1 comments

Animesh Dasgupta
29/12/2011

They best ever explaination for currency fluctuation i have ever gt till now

 

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