Currency Fluctuations and Its Impact on the Economy

Now and then, you keep reading about the currency fluctuations, especially given the current economic and political conditions; it seems to be hitting all-time highs or lows. Recently, the Indian rupee hit 83.3 against the $1 US dollar.

Currency Fluctuations and Its Impact on the Economy 

You know that currency is normally seen from the lens of exchange rates. In today’s era of globalization, the trading of goods and services is more common than ever between countries. And exchange rates define the price you pay for buying products from other countries. In this article, we’ll cover what currency fluctuation is and how it impacts the economy.

What is Currency Fluctuation?

Currency Fluctuation means the value of one country’s currency fluctuates with the value of another country’s currency. Every day, changes in the exchange rates between different currencies can impact their value. These changes happen regularly, and investors in currency exchange deals pay close attention to them to profit from their investments.

Think of it like this: if your country’s currency is weak, you pay a higher price on foreign goods than when the domestic currency is stronger in your country. But a strong domestic currency doesn’t always yield effective long-term results as entire industries will be rendered uncompetitive and thousands of jobs lost. 

On the other hand, a weaker domestic currency, whilst making your cross-border shopping and overseas travel more expensive, can also result in more economic benefits. Currency fluctuations impact the economy in every way, even in ways you do not think.

You may think that an average person, who is buying locally, will witness a fairly stable value of currency from day to day, and exchange rates only come into focus for occasional activities or business transactions such as import payments, overseas remittances, or leisure on foreign travel, any purchases. You are limiting your view and are mistaken to think it isn’t impacting you.

Directly or indirectly, currency fluctuations impact several key economic variables in the form of either the interest rate you pay on your mortgage, the returns on your investment portfolio, the price of groceries in your local supermarket, or your job prospects.

But before diving deeper into these direct and indirect impacts of currency fluctuations on the economy, let us understand that-

Why do Currencies Fluctuate So Often?

The answer is supply and demand. The value of anything is defined by the amount it is available plus how many desire to buy it. The same applies to currency as well. The world’s currencies are sold and bought based on their supply and demand in the foreign exchange market.

If demand increases for a particular currency, but it’s available in limited quantities, its value, aka exchange rate, will increase. At the same time, a decrease in demand or an influx in supply will lower its value. This equation is hugely impacted by factors such as the central bank’s monetary policy, inflation rates, and the conditions involved with a country’s political and economic environment.

These factors, however, are also affected by currency fluctuations; hence the cause and effect are the same in the cycle of economics.

Direct Impact of Currency Fluctuations on the Economy

As highlighted, currency fluctuations have both a direct and indirect impact. Former is seen in terms of numbers, charts, and trends in an economy on a macro-level in the following ways:

1. Foreign Trade

As discussed before, a weaker currency makes imports expensive for your country while the stimulation of exports becomes cheaper. This directly impacts a nation’s trade deficit or trade surplus over time.

For example, assume you are an Indian exporter who sells clothes at INR 500 each to a buyer in the US. The exchange rate is Rs. 70 = USD 1. Therefore, the cost to your US buyer is USD 7.14 per cloth.

Now let’s say the rupee weakens, and the exchange rate is Rs. 77= USD 1. Even if prices are negotiated, you will still be clearing more than before from the sale. A weak Indian rupee allows your export business to remain competitive in international markets.

Conversely, a stronger currency can widen the trade deficit and reduce export competitiveness, damaging export-dependent industries. While eventually, the currency will weaken in a self-adjusting mechanism, the damage would be done, impacting the economy severely and lowering the value of a nation’s GDP.

2. Foreign Capital

Stronger the government, the more viable the dynamicity of the economy, and the more stable the currency, the more the inflow of foreign capital from investors. Currency fluctuations first deter overseas investors before impacting others.

Governments prefer FDI (foreign direct investment, where investors take stakes in existing companies) over Foreign portfolio investment (investors trade securities) since the latter leaves faster when currency fluctuates. Despite this, capital flights happen when conditions grow tough.

3. Country’s Inflation

Let’s go back to the example from point 1.

With a weaker currency, exporters were happy but what about the importers? They now have to pay more for imported goods, which impacts the price they will sell into the domestic markets. Hence, a devalued currency may cause “imported” inflation for countries with substantial importers.

4. Prevailing Interest Rates

Now, extending from point 3, the inflation rate is pushed in a nation that is a big importer; to counter the inflation rate and prevent the currency from plunging sharply, the central bank will raise interest rates, tightening the monetary policy. Conversely, a strong currency depressing inflation rates will exert a drag on the economy, where any tightening of the monetary policy at a time of strong domestic currency will attract foreign investors seeking higher-yielding investments (which would further strengthen the domestic currency).

Indirect Impact of Currency Fluctuations

Like an iceberg, you see the macro impact of currency fluctuations while the major ground-level impact remains hidden. Unlike the direct impact, the indirect impact is seen at the micro-level; from the prices you pay at the supermarket, the interest rates on your loans, mortgage, and savings account, the returns on your investment portfolio, your job prospects, to the housing prices in your area.

If economic growth is fast, you have better employment prospects when the domestic currency is strong, curtailing the employment prospects.

The impact of currency fluctuations is seen on the economy in every way, not just domestically but globally, from the highest rungs of government to the smallest piece of clothing you import. Understanding these variations is not just important for governments, businesses, or investors but also for you as a household member. Knowing can always help you make financial decisions better, know when to invest and where, and have a portfolio that yields better. It is smart to save for rainy days but even smarter to know when that day may arrive.

Wrapping Up

Currency fluctuations are important for the global economy and can affect countries, businesses, and individuals in various ways. Governments and central banks have a role in managing these fluctuations, and businesses and investors can take advantage of them to generate profits or manage risks. 

It’s important to understand the impact of currency fluctuations to make wise decisions and navigate the complexity of the global economy. By keeping an eye on currency fluctuations and responding appropriately, stakeholders can benefit from the opportunities and minimize the risks that come with them.