With
trillions of dollars traded between hands every day. The money market is the
largest and most liquid market in the world. There is no gathering place instead,
the forex market is an electronic network of institutions, banks, brokers, and
individual traders. (Mainly through brokers or banks).
The market determines the value of most currencies, which is commonly referred to as an exchange rate. One foreign exchange requirement can be met by merely exchanging one currency for another at a nearby bank. Currency trading on the foreign exchange market is an additional choice. For instance, an investor can stake money on the possibility that a central bank will ease or tighten monetary policy as well as the strength of one currency vs. another.
Many factors can potentially influence the market forces behind foreign exchange rates. The factors include various economic, political, and even psychological conditions. The economic factors include a government's economic policies, trade balances, inflation, and economic growth outlook.
Main causes of fluctuations in exchange rates of international payments
1. Trade Movements
2. Capital Movements
3. Stock Exchange Operations
4. Speculative Transactions
5. Banking Operations
6. Monetary Policy
7. Political Conditions
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 favor 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
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 unfavorably for the home country. But, when foreigners repay their loan, the demand for home currency exceeds its supply and the rate of exchange becomes favorable.
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: Banks are the major dealers in foreign exchange. They sell drafts, transfer funds, issue letters of credit, accept foreign bills of exchange, take up arbitrage, etc. These operations influence the demand for and supply of foreign exchange, and hence the exchange rates.
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.
8. Inflation Rates: Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another's will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest 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.