What causes currencies to fluctuate?
You might be hearing these days about some currency rates jumping to all-time highs while others are plunging to record lows. Currency exchange rates are constantly fluctuating, they follow a simple economics theory based on supply and demand.
Most of the 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. A high demand for a currency or a shortage in its supply will cause an increase in price. A currency’s supply and demand are tied to a number of factors including the country’s monetary policy, the rate of inflation, and political and economic conditions.
- Monetary policy is the control of how much money is available in an economy and the channels by which new money is supplied. It is one way a country may stimulate its economy. Many central banks attempt to control the demand for currency by increasing or decreasing the money supply and/or by benchmarking interest rates.
- Another variable that heavily influences the value of a currency is the inflation rate. The inflation rate is the rate at which the general price of goods and services are increasing. While a small amount of inflation indicates a healthy economy, too much of an increase can ultimately lead to the currency’s depreciation.
- The economic and political conditions of a country can also cause a currency’s value to fluctuate. This is why currencies from politically stable and economically sound countries generally have higher demand, which, in turn, leads to higher exchange rates.
Markets continually closely watch the current and expected future economic conditions of countries. In addition to money supply changes, interest rates, and inflation rates, other key economic indicators include gross domestic product, unemployment rate, housing starts, and trade balance (a country’s total exports less its total imports), if these indicators show a strong and growing economy, its currency will tend to appreciate as demand increases.
Similarly, strong political conditions impact currency values positively. If a country is in the midst of political unrest or global tensions, the currency becomes less attractive and demand falls.
Many factors related to basic economic demand and supply affect currency values and rates. What has been shown is that more knowledge and in depth study of market conditions and their implications for currency fluctuations leads to more accurate predictions.
It is worth mentioning here that Investors consider the UAE dirham to be among the world’s most stable currencies in terms of exchange rate stability. It has been pegged to the United States dollar since 1997 at a rate of 1 U.S dollar to 3.6725 AED.