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Posted July 26th, 2013 by Charles Purdy

What factors affect exchange rates and currency fluctuations?

Why are exchange rates so important? They determine levels of trade between countries, but also the exchange of currencies. Fluctuations can cause huge variation in the amount of foreign currency your pounds are worth. So what causes these fluctuations and how can they be best used to your advantage?

For those of you who don’t know, the exchange rate is the price of a currency in terms of another. There are an array of factors which determine this; inflation, interest rates, the balance of payments, speculation, debt and political stability. Fundamentally it is changes in the supply and demand for money that causes these rates to fluctuate. Any shift in the economy, caused by any of the previous factors, will directly alter either the supply or demand for the currency.

Inflation

If the UK is experiencing inflation it will become less internationally competitive as the prices of UK goods increase. This will lead both UK and foreign consumers to switch away from UK goods, increasing imports and decreasing exports. This can cause a current account deficit on the Balance of Payments. This lack of demand for UK goods will subsequently mean a lack of demand for pound sterling, and this decrease in the pressure on the current supply of pounds will cause a fall in its value.

Interest rates

Interest rates can have two effects on exchange rates. Firstly, low interest rates tend to cause inflation as they stimulate borrowing and encourage spending in the economy. Secondly, if the UK interest rate is low relative to elsewhere it will become less attractive to deposit money into the UK as investors are looking for the highest possible return on their investments. Therefore the demand for pounds will fall, causing the exchange rate to fall further.

Speculation

Investor’s decisions determine the level of capital in the economy. If the UK is attracting foreign direct investment, the demand for the pound increases and it will strengthen. Speculators buy currencies that they expect will strengthen with the intention of selling the currency once the exchange rate has risen. Speculators are incredibly influential in financial markets as they deal in such large amounts of currency, creating great demand or huge supply for the currency. In the short term, speculation is considered to be the main cause of fluctuations.

In the long term, with a floating exchange rate system such as exists in the UK, prices will adjust to oppose any changes in the exchange rates and bring the rates back to equilibrium. Purchasing power parity theory states that a good sold in different countries should have the same price when expressed in units of one currency.  Therefore it is in the short run that these fluctuations can be damaging, and it is important for businesses and individuals to take measures to protect themselves from these changing rates. Smart currency exchange is here to help you do just that.

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