Firstly, what are currency fluctuations? They’re the changes to the value of one currency when compared to another. If one pound sterling is worth $2 today, and then $1.80 tomorrow, then the pound has fluctuated in value by $0.20¢.
An event like Brexit perfectly illustrates the cause of currency fluctuations. We all know that exchange rates can fluctuate from one moment to the next – after all, it’s the comparison of two different currencies – but the reasons behind the numbers are harder to grasp.
Following the Brexit vote in 2016, the pound’s value fell by more than seven per cent against the euro. The pound sterling then rallied and became the stronger currency.
But what caused this foreign exchange rate to fluctuate?
Why do foreign exchange rates fluctuate?
At the root of all currency fluctuation is the basic principle of supply and demand.
In the midst of Brexit’s economic uncertainty, the pound sterling became less attractive and the demand for it fell. Whereas, had Brexit been a sign of economic stability, the demand for pound sterling would have grown.
In countries that have a floating exchange rate, a currency is just like any commodity: if it’s in high demand (which often goes hand-in-hand with being in short supply), it will cost more.
A floating exchange rate is a rate that changes according to supply and demand. And supply and demand for currency is influenced by a variety of things like:
- Interest rates.
- International trade.
- Political upheaval.
- Foreign investment.
- Economic uncertainty.
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How do interest rates affect currency fluctuation?
Money supply and interest rates are two main factors that affect demand for a currency. Both factors can be controlled by governments to manipulate their economy and their domestic currency.
In the UK, the Bank of England sets the official interest rate, known as the base rate, which determines the interest rate when you borrow money. The base rate is currently 0.5 per cent, up from 0.25 per cent in 2021. In November 1979 it reached a peak of 17 per cent.
Money supply is the total amount of money that’s in circulation in a country. If there’s a large amount of it in circulation, the value of that currency will decrease against foreign currencies and the exchange rate will dip. High money supply is also linked to low interest rates (again, because a larger supply means lower demand).
Lower interest rates, in turn, also tend to make a currency drop in value – because investors get low returns on investments in that currency. This may make low interest rates seem like bad news. But there’s another reason why governments may choose to lower interest rates. When rates are low, people borrow and spend more, which usually fuels economic growth.
How does inflation cause currency fluctuation?
There’s yet another twist to watch out for, and that’s inflation. If inflation gets too high, because demand for goods exceeds supply, it can cause economic instability and currency depreciation.
Put simply, people can’t afford to buy all the same things they used to, so businesses may struggle to sell products and services. A central bank may then attempt to counteract inflation by raising interest rates, thus encouraging people to put their money into a savings account rather than spend it on goods. This means that demand drops and inflation slows down.
We’ve seen how low interest rates generally make for low exchange rates. But the converse is also often true: higher interest rates are generally associated with higher exchange rates because investors get a higher return on their assets compared to the same assets in another currency.
How does market stability affect the exchange rate?
Related to all of the above is one overarching factor: stability. The market loves stability and is constantly monitoring economic indicators and current events to find where it exists and where it may be lacking. A strong, stable economy – with consumer confidence reflected in a good degree of spending, low unemployment, a buoyant housing market and increasing gross domestic product (GDP) – encourages investment and increases demand for a nation’s currency.
However, if the country is going through a period of political upheaval, these economic factors pale into insignificance. Political unrest is often the signal of doom for a country’s economy. This discourages foreign investment and often leads to a decrease in demand for the currency and its value drops across the globe. So when it comes to maintaining the value of a currency in the long term, confidence and stability are the key.