Why do currency value Fluctuates?

Every country in the world usually has a currency that is specific to the country. But all Currencies in the world do not have equal value and the value of currency keeps on changing. Most of the world’s currencies are bought and sold based on flexible exchange rates, Currency value of a country keeps on changing. One Indian rupee in 1947 is not the same as one rupee today, both in terms of purchasing power and appearance. Why do Currency Value changes? What is the Foreign Exchange Market? Types of Foreign Exchange Rate

India vs US dollar over time

Foreign Exchange Rate

Every country in the world usually has a currency that is specific to the country.  There are more than 185 different currencies in the world. However, according to the United Nations, only 180 of these currencies are internationally recognized.

Some currencies are greatly valuable; some are fairly valuable. One US Dollar ($1) for example, is not equivalent to an Australian or Canadian Dollar. Euros and Pounds are worth different amounts and so on.

Currency is an accepted form of money, including coins and paper notes, which is issued by a government and circulated within the country. It is used as a medium of exchange for goods and services.

Our article What is Currency? explains the currency in detail and Currencies of the World, Tricks to Remember Currencies

A country has its own currency. But a country may need to buy from other countries i.e import goods or sell to other countries i.e export goods.  Imagine that you are buying something from a company in China, and you live in America. Chinese company needs to be paid in renminbi, which is their local currency but you have dollars, so there needs to be some way to convert between the two.  If you have $100 but you need renminbi you want to try to get as many renminbis for your $100 as you can.  This is where currency exchange comes in.

The exchange rate is defined as “the rate at which one country’s currency may be converted into another”. Currencies are traded against one another in pairs. For instance, the quotation EURUSD (EUR/USD) 1.5465 is the price of the Euro expressed in US dollars, meaning 1 euro = 1.5465 dollars

Foreign exchange market

Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers, and where currency trading is continuous, 24 hours a day except weekends

The foreign exchange market works through financial institutions, large international banks, and operates on several levels. Behind the scenes, banks turn to a smaller number of financial firms known as “dealers”, who are involved in large quantities of foreign exchange trading.

Forex has little (if any) supervisory entity regulating its actions.

The modern foreign exchange market began forming during the 1970s. This followed three decades of government restrictions on foreign exchange transactions under the Bretton Woods system of monetary management, which set out the rules for commercial and financial relations among the world’s major industrial states after World War II.

According to the Bank for International Settlements, trading in foreign exchange markets averaged $6.6 trillion per day in April 2019, up from $5.1 trillion in April 2016.

Types of Foreign Exchange Rate

Fixed exchange rate

Some countries “peg” their currencies. They’ve decided in advance that there is some ideal exchange rate between their currency and some other currency (or some other basket of currencies) and they’ll try to maintain that. So, for example, the Nepalese government has pegged its exchange rate so that 1.6 Nepalese rupees equals one Indian rupee. This is also called a fixed exchange rate.

Fixed exchange rate does not mean the value of the currency will not change. It means that the value of the currency will move in tandem with the currency or currencies to which it is pegged i.e. the ratio of the value of the currencies will be maintained. The exchange rate will not change every day but it may be reset on particular dates known as revaluation dates.

Fixed Exchange Rate was the norm from the end of the Second World War until the 1970s, when the global system of fixed exchange rates, called Bretton Woods, collapsed.

Before the period of economic liberalization in the 1990s, India followed a fixed exchange rate system. The Indian rupee was pegged to the US dollar and a basket of other currencies. The RBI maintained a reserve of US dollars to ensure a fixed exchange rate.

Free-floating Exchange Rate

But most countries leave the currency to market forces, called as free-floating.  That means a currency is worth the price a buyer is willing to buy it at.

Most 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.

The foreign exchange rate for conversion of currencies depends on the market scenario and the exchange rate being followed by the countries. Floating exchange rates or flexible exchange rates are determined by market forces. For instance, due to heavy imports, the supply of the rupee may go up and its value falls. In contrast, when exports increases and dollar inflows are high, the rupee strengthens.

However, there is no true free-floating regime. The central banks always influence these rates so that they do not deviate too much. They achieve this influence by either selling or buying the currencies on the foreign exchange market. Apart from supply and demand, the value of a country’s currency is largely decided by market forces and is linked with its economic conditions and policies such as economic stability, inflation, foreign trade, employment, interest rates, growth rate and geopolitical conditions.

Why does Currency Value keep on changing?

The currency value of a country keeps on changing. One Indian rupee in 1947 is not the same as one rupee today, both in terms of appearance and purchasing power. The value of a country’s currency is linked with its economic conditions and policies. 

The value of a country’s currency is largely decided by market forces and is linked with its economic conditions and policies such as economic stability, inflation, foreign trade, employment, interest rates, growth rate and geopolitical conditions.

Factors that affect the value of a currency

Apart from supply and demand, the following factors determine the exchange rate of a currency

Inflation in the country

Inflation brings about a fall in purchasing power of the currency and thus its value.

While a small amount of inflation indicates a healthy economy, too much of an increase can cause economic instability, which may ultimately lead to the currency’s depreciation.

A country’s inflation rate and interest rates heavily influence its economy. If the inflation rate gets too high, the central bank may counteract the problem by raising the interest rate. This encourages people to stop spending and instead save their money. It also stimulates foreign investment and increases the amount of capital entering the marketplace, which leads to an increased demand for the currency. Therefore, an increase in a country’s interest rate leads to an appreciation of its currency. Similarly, a decrease in an interest rate causes depreciation of the currency.

Current account deficit

A current account represents a country’s foreign transactions. Current account deficit implies that a country is spending more money on importing goods and service from abroad than earning money via exports. Since importing of goods and service is more than exporting, and imports have to be paid in foreign currency, this increases the demand for that currency and hence its value appreciates with respect to the rupee. If the vice versa was the case where exports are greater than imports, then the value of the rupee will appreciate with respect to the foreign currency.

Amount of public debt

If a country has a high level of budget deficits and is borrowing to cover this cost, then it would result in lower currency valuation.

A country with a huge amount of public debt carries a very high risk of inflation. It must either print new currency to pay off its debts (which again increases inflation) or increase the sale of securities to foreign investors, hence lowering their prices.

If the debt is too large and investors are not confident in the country’s ability to pay back its debts, then they will not be willing to buy securities denominated in that currency. Thus inflation will go up and currency valuation will go down.

Stability and economic growth

Where do you think foreign investors will put their money? In a war-torn country with no government, no economic policy and a destroyed economy or in a stable, strong and developing economy like India’s?

Foreign investors are looking to profit from their investments. Hence it is important for a country to a have a stable government and sound economic policies to attract investments. More foreign investments imply higher demand for the rupee and hence its price will appreciate.

India and US Exchange Rate History