Why do Currencies Fluctuate?

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Why Currencies Fluctuate

  1. Currency fluctuation is the change in the value of the exchange rate of one currency against another.
  2. It is caused by a number of factors, with the simple explanation being that the changes in value are effected by the supply and demand principal.
  3. More specifically, the biggest impacts on the value of a currency are the Inflation and Interest Rates of a country, as determined by its Central Bank.
  4. A countries trade deficit level and the size of its national debt can also have a big impact on the currency rate.
  5. Finally, the importance of a stable political and economic situation in a country cannot be stressed enough.

What we mean by Currency Fluctuations

Everybody has come across the concept of exchange rates – the value your money is worth in a foreign currency – when travelling abroad on holiday. And most of us will also be aware that at different times, our money has been worth different amounts.

For example, if you are travelling to anywhere in the Eurozone today, you will find you get a significant amount more for your money than you would have done ten years ago. But of course in ten years’ time, this might have all changed again.

What many of us don’t know if what it is that makes currencies move up and down in relation to each other. This guide will explain exactly what the key factors are in this fluctuation in the value of currencies and how we can identify the most countries where our money might go that little bit further.

Exchange Rates

An Exchange rates specifies how much one currency is worth compared to another. An easy example is to say that if there is an exchange rate of For example, an exchange rate of 1.56 US dollars ($) to the pound, this means that for every £1 you have, you will be given US$1.56 when you exchange it, to be used in the USA.  

Most Currency Exchanges will also charge a commission and take a small amount of the rate with each transaction, which is why when you go to exchange money you will usually see two exchange rates, one for when they are buying currency, and one for when they are selling it. The actual exchange rate will sit somewhere in between the two.

For most people that is the extent of their interaction with currency exchange rates, but in actual fact there is a huge and thriving financial market in currency exchange on which vast amounts of currency – some estimates put the amount in excess of US$3 trillion every day – is exchanged by financiers looking to make money from the changes in currency values.

Supply and Demand – the simple answer

Needless to say there are many intricate factors that can impact on such a large financial market as currency exchange. Further down this article we have explained a few of the common causes for the changes in the value of currency, but there is also a straight-forward answer as well – Supply and Demand.

Supply and Demand is a concept that be applied to almost all goods and services, and currencies are no different. When the demand for a currency goes up, and becomes greater than the supply of that currency is available, then the value of that currency will rise. If demand drops, and becomes less than the supply available, the value of the currency goes down.

A decrease in demand does not have to mean that people don’t want the currency anymore, it just means they are choosing to store their money in a different way – for example a different currency.

Explaining what causes the changes in supply and demand of currency is a little more complicated and delves into the world of macroeconomics. We will take a look at five key factors here, noting that there are many more smaller details which can also impact on exchange rates.

Inflation

A country’s inflation rate is an important factor in whether their currency is rising or falling in value. This is the rate at which the cost of living is increasing in that country. Most countries aspire to have a small but steady rate of inflation each year. The UK Government’s current target for inflation is 2% a year.

Generally speaking, it is countries with lower inflation which experience rising currency values, because its ability to purchase goods and services is going up in relation to other currencies with higher inflation.

In contrast, countries with higher inflation will see the value of their currency dropping compared with trading partners with lower inflation.

It is this scenario that usually leads to higher Interest Rates.

Interest Rates

Interest Rates are always closely linked to a countries inflation rate, and it indeed the value of its currency. They are controlled by a country’s Central Bank – the Bank of England in our case.

When the Bank of England chooses to put interest rates up, this means lenders will receive a higher return, and foreign capital is therefore attracted to the country. As a result, the value of that country’s currency will go up because the demand will begin to outstrip the supply.

However if the country already has a high inflation rate, this can mitigate the effect of the exchange rate rise and mean it has less of an impact on the currency.

The opposite effect can be had if the Central Bank chooses to lower interest rates.

Trade Deficits

Trade deficits relate to the amount of money a country is spending on trading goods, services, interest and dividends with its trading partners.

If a country is spending more on foreign trade than it is receiving, then it will be running a trade deficit and therefore will be borrowing from overseas to make up the difference.

This demand within the country for an external currency has the effect of lowering that countries currency value until such a time as domestic goods and services are cheap enough for the balance of trade of be restored.

The National Debt

The UKs National Debt has received a lot of coverage since the economic crash of 2008, as the consistent running of a deficit in public spending has seen it spiral to record highs. It currently stands just short of £1.5 trillion, and is still growing year on year.

This figure still pales in comparison to the USA whose national debt is currently around US$18.5 trillion for the Federal Government alone. Obviously the UK and the US have two of the most reliable economies on the planet, but the impact of that national debt can be felt in the strength of their respective currencies.

Quite simply nations with large national debts are less attractive to investors because a high debt can encourage higher inflation, and make it more likely that they will be unable to repay that debt.

A countries national debt plays a vital role in its debt rating, as established by independent organisations such as Standard and Poors or Moodys). This rating establishes how likely a country is to be able to repay its debt, and the level it is set at plays a big role in determining the value of that country’s currency. If a country’s debt rating is cut, its currency value will quickly drop as well.

Political and Economic Stability

Lastly, when an investor is deciding where to put their capital, they will be searching for a country which has a stable economy, and where there is little risk of political upheaval.

If a countries economy has a track record of behaving erratically, this can have an impact on your investment, and any political crisis to hit a country will also always affect its currency value almost immediately.

Therefore if a country can offer an established political system and a stable economic record, demand for its currency will remain high, and this will strengthen its value.

Getting the best deal on your Currency Exchange

So how does all of this affect you when looking to find a good deal on exchanging currency?

Put simply, if you want to get better value from your holiday, the best places to look are those countries where demand for their currency is low.

Obviously take this as a broad guide, as many countries that fall into this bracket may not be a perfect holiday destination. Always check with the Foreign and Commonwealth Office on the safety of a destination before going there. But there are plenty of destinations in Europe, particularly south-east Europe which fall into this bracket, as well as quite a few popular destinations in the Far East and the Caribbean.

Once you have chosen, shop around for the best available rates too. Airport Currency Exchanges always have punitive rates, so try your local banks, and even look online too. With the right research, you could be set for a cut-price holiday thanks to your understanding of the fluctuations in currency rates.

Further Reading

  • If you are interested to learn more about the financial market in foreign currency exchange, take a look at our Guide to Forex Trading.
  • We also recommend the Top Ten websites where you can indulge in a little currency trading yourself.
  • If you want to learn more about National Banks, take a look at our guide to the Top Ten Central Banks.  
 
6 comments
Mpho Poustarico Motshegwa Mpho Poustarico Motshegwa
19/08/2012

straight to the point I like nd yah thanx

 
Laxman Tandon Laxman Tandon
16/07/2012

Understood.

 
krupa krupa
06/07/2012

fantastic information

 
Ronak Ronak
17/05/2012

fantastic explanation, thank you.

 
Anju Lisanne Anju Lisanne
03/04/2012

Wooh! A perfect explanation.Short and sweet. Very helpful

 
Animesh Dasgupta Animesh Dasgupta
29/12/2011

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

 

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