If one US dollar is worth a value in your home country's currency today, and then another value tomorrow, how does that affect you or anyone earning in such a currency? Image Credit: Jason Leung/Unsplash

Dubai: A fluctuating currency? They're nothing but the changes to the value of one currency when compared to another.

If one US dollar is worth a value in your home country's currency today, and then another value tomorrow, how does that affect you or anyone earning in such a currency?

You may think you have or are earning the same amount of money before the last depreciation in the currency’s value. So, you can buy the identical amounts of goods or services as before.

However, it does not work like that. Let’s unpack this and first look at how a weakening currency affects us - albeit indirectly.

How has money evolved from minted coins to banknotes and now digital currencies? Let's track the history of money, from tradable objects, to precious metals and currently cryptocurrencies. Vijith Pullikal/Gulf News

How do currency fluctuations impact us?

“As one of the leading factors behind the economic health level of any given country, exchange rates are one of the most analysed economic measures on the planet,” remarked Dubai-based forex specialist Ebin Wilson.

“This is why knowing what exactly influences currency exchange rates and why they are so important to everyone from governments and large financial institutions to small investors, is crucial.”

Knowing what exactly influences currency exchange rates and why they are so important to everyone is crucial

- Ebin Wilson, Dubai-based forex specialist

When a currency slides, the government will have a reduced capacity to spend on infrastructure building and other welfare projects. Investment goes down, and this in turn affects unemployment numbers, which will affect a country’s residents the most.

A falling currency also makes your overseas education and travel costlier because your fees and tickets cost more in line with the value of the US dollar. On the other hand, this is also why a strengthening currency will benefit you.

How oil prices affect currencies

High crude oil prices not only mean costlier petrol and diesel for vehicle owners, but transportation of essential commodities, including fruits, vegetables, and edible oil and food grains, also costs more.

All this leads to inflation, and a depletion of our forex reserves because we’re sending out more dollars on crude oil. This reduces our ability to import other goods that we need.

"If the concerned currency belongs to a country that’s dependent on import, this leads to fewer and costlier foreign goods, and a further weakening of the currency. If you shop, you spend more,” explained Wilson.

“If you hold back spending, this causes demand for goods and services to go down - activities like construction, manufacturing and imports slow. Companies can hire fewer employees. The overall economy takes a hit. You feel the pinch of the currency’s slide.”

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Who decides the value of a currency?

A currency is a state of flux that stems from uneven supply and demand in the foreign exchange market, an institution for the exchange of one country's currency with that of another country.

So simply put, currencies fluctuate based on supply and demand for a given currency. Most of the world's currencies are bought and sold based on flexible exchange rates, meaning their prices fluctuate based on the supply and demand in the foreign exchange market.

Foreign currency exchange rates are floating and depend on daily market factors like demand and supply, with zero or little intervention from the countries involved. The more the demand, the greater the value.

For example, heavy imports, which mean more dollars purchased, decrease the value of the Indian currency, the Indian rupee (INR). Similarly, in the case of heavy exports, more dollars will flow into India and become cheaper for residents to buy through the Indian rupee.

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3 key economic factors that force a currency’s value to fluctuate

• Monetary policy

Many countries’ central banks attempt to control the demand for currency by increasing or decreasing the money supply and/or benchmark interest rates. The money supply is the amount of a currency is printed and in circulation.

As a country's money supply increases and the currency becomes more available, the price of borrowing the currency goes down. The interest rate is the price at which money can be borrowed. With a low interest rate, people and businesses are more willing and able to borrow money.

As they continually spend this borrowed money, the economy grows. However, if there is too much money in the economy and the supply of goods and services does not increase accordingly, prices begin to inflate.

• Rate of inflation

Another variable that heavily influences the value of a currency is the inflation rate. The inflation rate is the rate at which the general price of goods and services are increasing.

While a small amount of inflation indicates a healthy economy, too much of an increase can cause economic instability, which may ultimately lead to the currency's depreciation.

A country's inflation rate and interest rates heavily influence its economy. If the inflation rate gets too high, the central bank may counteract the problem by raising the interest rate. This encourages people to stop spending and instead save their money.

It also stimulates foreign investment and increases the amount of money entering the marketplace, which leads to an increased demand for currency. Therefore, an increase in a country's interest rate leads to an appreciation of its currency. Similarly, a decrease in an interest rate causes currency depreciation.

• Political and economic conditions

The economic and political conditions of a country can also cause a currency's value to fluctuate. While investors enjoy high interest rates, they also value the predictability of an investment. This is why currencies from politically stable and economically sound countries generally have higher demand, which, in turn, leads to higher exchange rates.

Markets continually monitor the current and expected future economic conditions of countries. In addition to money supply changes, interest rates, and inflation rates, other key economic indicators also include unemployment rate and trade balance (a country's total exports minus its total imports). If these indicators show a growing economy, its currency will tend to appreciate as demand increases.

Similarly, strong political conditions impact currency values positively. If a country is in the midst of political unrest or global tensions, the currency becomes less attractive and demand falls. On the other hand, if a market sees the introduction of a new government that suggests stability or strong future economic growth, a currency may appreciate as people buy it based on the good news.

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How is the value of various currencies set or measured? 

The most common way to measure currency value is by measuring its convertibility to other currencies – also known as the exchange rate.

1. Fixed Exchange Rate

A fixed exchange rate is when one country pegs its currency to an anchor currency so that both currencies move identically. Countries that opt for a fixed exchange rate are usually developing countries.

The most common anchor currency is the US dollar since it is relatively stable and considered a safe haven in crises. At times, a country can also peg the currency value to a basket of currencies.

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2. Floating Exchange Rate

A floating exchange rate involves letting the foreign exchange market determine currency value with respect to the supply and demand of other currencies. Countries under a floating rate system may experience higher exchange rate volatility.

However, countries with a floating exchange rate also benefit from exercising more autonomy. The government usually still intervenes occasionally to keep the exchange rate within a reasonable fluctuation band.

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How can currency fluctuations be stopped?

Central banks and governments can intervene to help stabilise a currency by selling off reserves of foreign currency or gold, or by intervening in the forex markets.

Foreign exchange intervention can be done in two ways. Firstly, a central bank or government may assess that its currency has slowly become out of sync with the country's economy and is having adverse effects on it.

For example, countries that are heavily reliant on exports may find that their currency is too strong for other countries to afford the goods they produce. They may intervene to keep the currency in line with the currencies of the countries which import their goods.

Image Credit: Vijith Pullikal/Gulf News

Bottom line: Why understand currency fluctuations?

Currency fluctuations have a significant impact on us. For example, buying a foreign car might get more expensive if your country's currency depreciates, which means that you might end up paying more money to get an item of the same value. On the other hand, a stable currency allows us to buy more.

When you travel overseas, one of the routines you become accustomed to be exchanging your currency for the local currency. Many people get surprised by the different amounts of local money they have once their currencies are turned in.

Clearly, fluctuating global currencies are a constant in volatile international capital markets. Consequently, there can be plenty of ways to capitalise on the wide swings of currencies.