Factors Affecting Exchange Rate Volatility

Factors Affecting Exchange Rate Volatility

Foreign Exchange rate is an important parameter that determines the economic health of a country. Many countries watch their foreign exchange rates closely because they provide a window to economic stability. Exchange rate refers to the value at which a country’s currency can be converted into another. On the other hand, exchange rate volatility is the likelihood of the value of a currency to fluctuate when measured against foreign currencies. There are various factors affecting exchange rate volatility, depending on market supply of demand and supply of currencies.

Economic factors affecting exchange rate volatility

Inflation is the main determinant of foreign exchange rate fluctuations. Any change in market inflation will always result into a change in currency exchange rates of a country. A country that has a lower inflation rate than another will experience an appreciation of its currency value.

Moreover, the price of goods and services in the market will increase slowly when the inflation is low. Thus, a country that maintains low inflation rates, will exhibit a rising currency value while a country with high inflation rates experiences deprecation of its currency value. When this happens, interest rates together with the prices of goods and services in the market go up. Inflation is so significant that it tends to influence other factors effecting exchange rate volatility.

Another element that affects currency exchange rate is interest rates. Normally, fluctuations in interest rates will affect the country’s currency value and the dollar exchange rate. In fact, inflation, interest rates and exchange rates are all correlated. Higher interest rates will result into appreciation of a country’s currency since higher rates give higher rates to lenders, which in turn attract more foreign capital. This leads to a rise in exchange rates.

Government debts vs. exchange rates

A country’s balance of payment has a direct bearing on exchange rate values of its currency. The current account of a country always shows a balance of trade and revenue on foreign investment. It puts together all transactions such as imports, exports, and debts among others. When a country registers a deficit in its current account because of overspending on imports more than its sales from exports, this will lead to deprecation. Therefore, the balance of payment affects exchange rate volatility.

Government debt refers to public debt or a national debt, which the central government owns. When a country has a huge public debt, it is likely to resort to acquiring foreign capital, resulting into inflation. Foreign investors react to this by selling off their bonds in the open market whenever they predict a public debt in a particular country. Thus, the government must tame its public debt in order to mitigate other factors affecting exchange rate volatility.

Critical factors affecting exchange rate volatility of a country

Terms of trade refers to the ratio of export to import prices. A country is said to have good terms of trade if its export prices rise above import prices with a huge margin. The result of this is higher revenue, coupled with increased demand for the country’s currency and appreciation of the currency. The overall impact of this is an increase in the exchange rate.

Moreover, the political state, stability and performance can have significant impact on a country’s exchange rate. A politically stable country is likely to attract investors from foreign countries experiencing the same political and economic stability. As the level of foreign capital goes up, the value of its domestic currency goes up. Thus, a country prone to political turmoil is likely to experience depreciation of its exchange rates.

Furthermore, recession breeds low interest rates and plummeting chances of getting foreign capital from investors. The impact of this is a weak currency measured against foreign currencies, leading to a drop in exchange rate. Lastly, exchange rate fluctuations depend on speculations in the market. If the value of a country’s currency is expected to rise, the demand for the currency will go high as investors expect more profit in days to come. This will lead to a sharp increase in the value of the currency and its exchange rate as well. From this discussion, it is evident that factors affecting exchange rate volatility are highly intertwined.

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