Main Causes of Fluctuations in Exchange Rates | International Trade
The various theories of exchange rate determination, as we have seen, seek to explain only the equilibrium or normal long period exchange rates.
In fact, there are various factors which affect or influence the demand for and supply of foreign currency (or mutual demand for each other’s currencies) which are ultimately responsible for the short-term fluctuations in the exchange rate.
Important among these are:
1. Trade Movements:
Any change in imports or exports will certainly cause a change in the rate of exchange. If imports exceed exports, the demand for foreign currency rises; hence the rate of exchange moves against the country. Conversely, if exports exceed imports, the demand for domestic currency rises and the rate of exchange moves in favour of the country.
2. Capital Movements:
International capital movements from one country for short periods to avail of the high rate of interest prevailing abroad or for long periods for the purpose of making long-term investment abroad. Any export or import of capital from one country to another will bring about a change in the rate of exchange.
3. Stock Exchange Operations:
These include granting of loans, payment of interest on foreign loans, repatriation of foreign capital, purchase and sale of foreign securities e c., which influence demand for foreign funds and through it the exchange rates.
For instance, when a loan is given by the home country to a foreign nation, the demand for foreign money increases and the rate of exchange tends to move unfavourably for the home country. But, when foreigners repay their loan, the demand for home currency exceeds its supply and the rate of exchange becomes favourable.
4. Speculative Transactions:
These include transactions ranging from anticipation of seasonal movements in exchange rates to the extreme one, viz., flight of capital. In periods of political uncertainty, there is heavy speculation in foreign money. There is a scramble for purchasing certain currencies and some currencies are unloaded. Thus, speculative activities bring about wide fluctuations in exchange rates.
5. Banking Operations:
6. Monetary Policy:
An expansionist monetary policy has generally an inflationary impact, while a constructionist policy tends to have a deflationary inflation. Inflation and deflation bring about a change in the internal value of money. This reflects in a similar change in the external value of money. Inflation means a rise in the domestic price level, fall in the internal purchasing power of money, and hence a fall in the exchange rate.
7. Political Conditions:
Political stability of a country can help very much to maintain a high exchange rate for its currency; for it attracts foreign capital which causes the foreign exchange rate to move in its favour. Political instability, on the other hand, causes a panic flight of capital from the country hence the home currency depreciates in the eyes of foreigners and consequently, its exchange value falls.