The Effects of Currency Fluctuations On The Economy:

The natural result of floating exchange rates, which are the norm for the majority of major economies, are currency volatility. Exchange rates are influenced by a variety of factors, such as a nation's economic performance, the likelihood of inflation, interest rate differences, capital movements, and more. A currency's exchange rate is often influenced by how well or poorly the underlying economy is doing. As a result, the value of a currency may change suddenly.

 

•    Trade in goods, economic expansion, capital flows, inflation, and interest rates can all be influenced by currency exchange rates.

 

•    The Asian Financial Crisis and the collapse of the Japanese yen carry trade are two examples of significant currency movements that had an impact on the financial markets.

 

•    Investing in international equities will help investors take advantage of a depreciating dollar. Their returns in terms of U.S. dollars can increase if the dollar declines.

 

•    By using securities like futures, forwards, and options, investors can reduce their exposure to foreign exchange risk.

 

Since they rarely need to, many people do not pay attention to currency rates. The normal person uses their local currency to conduct their everyday business. Only sporadic activities, such international travel, import payments, or international remittances, put exchange rates in the spotlight.

 

A strong home currency might appeal to a foreign traveler because it would make going to Europe more affordable. On the other hand, a strong currency can have a negative impact on the economy over time by making whole sectors uncompetitive and costing thousands of jobs. Although some people would prefer a strong currency, there may be more economic advantages to a weak currency. 

 

When setting monetary policy, central banks take into account a number of factors, including the value of the national currency in the foreign exchange market. The interest rate you pay on your mortgage, the returns on your investment portfolio, and the cost of food at your neighborhood grocery store, and even your employment chances may all be affected by currency levels, either directly or indirectly.

 

The following are some direct effects of currency level on the economy:

 

•    It means the imports and exports of a country. In general, a weaker currency raises the cost of imports while lowering the cost of exports for buyers abroad, which encourages exports. A country's long-term trade surplus or deficit can be impacted by a country's currency, which might be weak or strong.

 

•    Assume, for instance, that you are an American exporter selling widgets to a customer in Europe for $10 each. 1 euro is equal to 1.25 dollars. As a result, each widget costs €8 to your European customer.

 

•    Let's imagine the dollar declines and the exchange rate drops to $1.35 to the euro. You can afford to give your buyer a break while still making at least $10 per widget if they wish to haggle for a lower price. Even if you set the new pricing per widget at €7.50, representing a 6.25% discount for your customer, your price in dollars would still be $10.13 due to the current conversion rate. Your export company can remain competitive in foreign markets if the U.S. currency is weak.

 

•    In contrast, a stronger currency can make imports more affordable and less competitive, which might increase the trade deficit and ultimately weaken the currency through a self-adjusting mechanism. However, before this occurs, an excessively strong currency might harm sectors of the economy that depend on exports.

 

The fundamental formula for GDP is as follows:

•    GDP = C + I + G + (X-M) where, 

 

•    C = Consumption or consumer spending, the largest component of an economy 

 

•    I = Capital investment by businesses and households 

 

•    G = Government expenditure 

 

•    (X-M) = Exports- Imports, or net exports

 

It follows from this equation that a country's GDP will increase as net exports increase in value. As was previously said, the relationship between net exports and the value of the national currency is inverse.

 

•    Strong governments, vibrant economies, and stable currencies tend to attract foreign investment. For a nation to draw in capital from international investors, its currency must be comparatively stable. If not, the possibility of exchange-rate losses brought on by currency devaluation may discourage foreign investors.

 

•    Foreign direct investment (FDI), in which foreign investors acquire shares in already-existing businesses or construct new facilities in the recipient market, and foreign portfolio investment, in which foreign investors purchase, sell, and trade securities in the recipient market, are the two types of capital flows. For developing nations like China and India, FDI is an essential source of financing.

 

•    Foreign portfolio investments, which are hot money that can leave the country rapidly can worsen conditions, and are generally not preferred by governments over FDI. Any unfavorable circumstance, such as a currency devaluation, has the potential to cause this capital flight.

 

•    Inflation that is "imported" from other nations might come from a devalued currency. Import prices could increase by 25% in response to a sudden 20% decrease in the domestic currency since a 20% decline necessitates a 25% increase to get to the original price point.

 

•    As was already established, most central banks take exchange rates into account when determining their monetary policy. Governor of the Bank of Canada Mark Carney stated in September 2012 that the bank considered the ongoing strength of the Canadian dollar when establishing monetary policy. Carney claimed that one factor in his country's monetary policy being "exceptionally accommodative" for so long was the strength of the Canadian currency.

 

•    A tighter monetary policy has the same impact on the economy as a strong native currency (i.e. higher interest rates). Furthermore, tightening monetary policy at a time when the domestic currency is already strong could make matters worse by luring hot money from overseas investors looking for assets with greater yields (which would further strengthen the domestic currency).

 

•    More than $5 trillion is exchanged on the forex market every day, significantly more than is moved on the global stock market, making it the most active market in the world. Despite such massive trade volumes, currencies typically don't make headlines. However, there are instances when currency movements are substantial and have an international impact. Below are a few illustrations:

 

•    The Asian Financial Crisis, which started with the devaluation of the Thai baht in the summer of 1997, is a perfect illustration of the chaos brought on by unfavorable currency movements. The baht was heavily targeted by speculators, which led Thailand's central bank to drop its peg to the dollar and allow the currency to float, which led to the devaluation. The currency crisis spread to nearby nations including Indonesia, Malaysia, and South Korea, which experienced a severe contraction in their economies as a result of a rise in bankruptcies and a decline in their stock markets.

 

•    China maintained the Yuan at roughly 8.2 to the dollar between 1995 and 2005, allowing its export juggernaut to gain momentum from what trading partners claimed was an artificially depressed and undervalued currency. China replied to the escalating chorus of criticism from the United States and other countries in 2005. By 2013, the Yuan has appreciated steadily from over 8.2 RMB to the dollar to around 6 RMB.

 

•    Between 2008 and 2013, one of the most volatile currencies was the Japanese yen. Traders preferred the yen for carry trades, in which they borrowed yen for virtually nothing and invested in higher yielding foreign assets, due to Japan's policy of near zero-bound interest rates. But when the global credit crunch worsened in 2008, terrified investors rushed to buy the yen in large quantities to pay off loans denominated in the currency.

 

•    As a result, in the five months leading up to January 2009, the yen increased in value relative to the dollar by more than 25%. Then, in 2013, Prime Minister Shinzo Abe presented "Abenomics"—plans for fiscal and monetary stimulus—leading to a 16% decline in the value of the yen in the first five months of the year.

 

•    The euro fell 20% from 1.51 to the dollar in December 2009 to around 1.19 in June 2010 due to worries that the heavily indebted countries of Greece, Portugal, Spain, and Italy would be forced out of the European Union. Over the following year, the euro regained strength, but it was only short-lived. From May 2011 to July 2012, the euro had a 19% decline due to renewed concerns about the EU's breakup.

 

Here are some ideas for profiting from currency movements:

 

US-based investors who anticipate a decline in the value of the dollar should place their money in robust international markets, as the profits from foreign exchange trading will increase their returns. For example if there is a sharp rise in the value of the Canadian currency, returns on U.S. dollar investments made by American investors purchasing Canadian stocks in dollars would roughly be 137%, or 9% annually.

 

Numerous sizable multinational corporations with significant international income and profit sources are based in the United States. The weaker dollar boosts the profits of American multinational corporations, which should result in higher stock prices when the dollar is weak.

 

Since U.S. interest rates have been at historic lows since 2000, it is true that this has not been an urgent issue.

 

However, they will eventually rise once more. Investors who are enticed to borrow money at lower rates in foreign currencies at that time should keep in mind individuals who struggled to pay back borrowed yen in 2008. The lesson of the story is to never borrow money in a foreign currency that is likely to appreciate if you do not understand how to manage exchange risk or you are unable to do so.

 

Unfavorable currency movements can have a big effect on your finances, especially if you have a lot of exposure to foreign exchange. However, there are many ways to reduce the risk of currency fluctuations, including through the use of exchange-traded funds.

 

If you want to sleep at night, have a look at these possibilities.

 

Changes in the value of a currency can have a significant effect both domestically and internationally. When the dollar is weak, investors might profit by making investments abroad or in American multinational corporations. It may be prudent to utilize one of the numerous available hedging mechanisms to reduce the risk of currency changes because they can be a significant risk when one has a significant forex exposure.