Free Essay: Factors Affecting Exchange Rate Volatility
Exchange rates, just like prices of commodities, keep shifting. However, it should be noted that despite the volatility of exchange rates, they are not always similar in all countries. There are currencies whose exchange rates are on the low while others are doing quite well. A fluctuating exchange means a lot to a country since it has very dire consequences. Exchange rates have the greatest impacts on trading relationships between countries. When the exchange rates are volatile, international trade is depressed.
There are quite a number of factors that can affect the volatility of exchange rates like interest rates, inflation, current account deficits, terms of trade, public debt, economic performance and political atmosphere.
Whenever there is inflation, it means that the economy is not doing quite well. As a result of this, the value of currency sinks to lower level. This is because not many people will be interested in investing in that currency or even using it as a means of exchange. The demand for the currency will go down. Thus, it can be concluded that high inflation leads to low exchange rate. On the other hand, the exchange rate can be quite good if there is lower inflation.
Interest rates can also affect exchange rates in that; foreign capital is attracted when the interest rates are higher. This will result into an increase in exchange rate. On the other hand, the exchange rate will decrease if the interest rates are lower.
When a country has current account deficits, it is an indication that its spending on foreign trade is more compared to what it is earning. Besides, it can also show that the demand for foreign currency is so high. As a result of all these, the exchange rate of the country is brought down.
To those countries with huge public debts, there are higher chances that sooner or later, they will be faced with inflation. Debts are always a turn-off and will keep investors away from a country that is experiencing such a situation. When inflation sets in, the country’s currency will significantly begin to depreciate. In the same way, the exchange rate will also be impaired.
Increasing terms of trade can also affect the exchange rate volatility. Terms of trade can be said to be increasing when the exports of a country are rising a faster pace compared to imports. This results into an increase in the value of that country’s currency. With this, the exchange rate will also increase. In contrast, decreasing terms of trade can lead to lower exchange rates.
Countries that are faced with civil unrest and other form of political instability are always disadvantaged when it comes to international trade. That is the same situation that countries with weak economic performances also find themselves in. The reason for this is because political instability and poor economic performance make people to lose confidence in a country’s currency. This will lead to its devaluation, thus, volatile exchange rate.
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