What are some of the major factors that lead to fluctuating exchange rates? What steps can a government take to minimize the fluctuations in its exchange rate? There could be numerous factors that can lead to fluctuating exchange rates, but firstly it is important to define exchange rate. Exchange rate can be defined as the value of one currency for the purpose of conversion to another. For example, suppose country "A" is Canada and country "B" is Japan. Then the exchange rate is the number of Japanese Yen per Canadian dollar or, alternatively, the number of yen that can be bought with one Canadian dollar. There may be many factors that can cause fluctuations in exchange rates but we will discuss the major factors below. .
Response .
Economic Factors.
Inflation.
In general, a country that has lower level of inflation exhibits a higher currency value as the purchasing power of the currency increases compare to other currencies. During the last part of the twentieth century, the countries with low inflation included Switzerland, Germany, and Japan, while Canada and U.S. achieved low inflation only later. Those countries with relatively higher inflation rate generally experience depreciation in their currency value in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.
Interest Rates.
Interest rates, inflation and exchange rates are all highly correlated. Interest rate is considered to be the most influential factor that affects the exchange rate. Central bank sets the standard for interest rate which is the cost of borrowing money for financial institutions. Higher interest rate allows lenders to earn a higher return relative to other countries. Thus, by raising interest rates, it attracts foreign investments which cause the exchange rate to rise. However, the impact of higher interest rates is diminished if inflation in the country is much higher than in other countries, or if additional factors decrease the currency value.
