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Currency fluctuations impact and Exchange rates

Currency fluctuations1

Currency fluctuations impact and Exchange rates

Currency fluctuations are a natural result of floating exchange rates, which is the major norm for most economies. Numerous factors affect exchange rates, including a country’s economic performance, inflation, interest rate differentials, capital flows and so on. A currency’s exchange rate is determined by the strength or weakness of the implied economy. As such, a currency’s value can fluctuate momently.

Far-Reaching Currency Impacts

Many people are not paying attention to exchange rates because they rarely need to. Exchange rates will come into focus for occasional transactions, such as foreign travel or import payments.

An international traveler might harbor for a strong domestic currency because that would make traveling to Europe inexpensive. But the downside is a strong currency can exert serious drag on the economy over the long term, as entire industries are rendered noncompetitive and hundreds of jobs are lost. While some might prefer a strong currency, a weak currency can cause more economic benefits.

The value of the domestic currency in the foreign exchange market is a key factor for central banks when they set monetary policy. Direct or indirect effect, currency levels will play a role in the interest rate you pay (ex: your mortgage).

Currency Impact on the Economy

A currency’s level has a direct impact on the economy as follows:

Merchandise Trading

This refers to imports and exports. generally, a weaker currency causes imports more expensive, while stimulating exports by making them cheaper for overseas customers to buy. A weak or strong currency can contribute to a country’s trade deficit or trade surplus over time.

Conversely, a strong currency can reduce export competitiveness and make imports cheaper, which can cause the trade deficit to widen further, eventually weakening the currency in a self-adjusting mechanism. But before this happens, export-dependent industries can be damaged by an excessively strong currency.

Capital Flows

Foreign capital tends to flow into countries that have powerful governments, dynamic economies, and stable currencies. A country needs a stable currency to attract capital from foreign investors. Otherwise, the probability of exchange-rate losses inflicted by currency depreciation may restrain overseas investors.

There are two types of capital flows: the foreign direct investment (FDI), in which foreign investors take stakes in existing companies or build new ones in the recipient market; and the foreign portfolio investment, in which foreign investors buy, sell and trade securities in the recipient market. FDI is a crucial funding source for growing economies such as China and India.

Governments mostly prefer FDI to foreign portfolio investments, because the latter is investment money that can leave the country quickly when conditions are tough. This capital flight can be sparked by any negative event, such as a devaluation of currency.

Inflation

A devalued currency can result in inflation for countries that are substantial importers. A sudden 10% decline in the domestic currency could result in imports costing 15% more, as a 10% decline means a 15% increase is needed to get back to the original price point.

Interest Rates

As mentioned earlier, exchange rates are a key factor for most central banks when setting monetary policy. In September 2012, Central Bank of Canada governor Mark Carney said the bank took the persistent strength of the Canadian dollar into mind when setting monetary policy. Carney said the Canadian dollar’s strength was a significant reason why his country’s monetary policy had been highly accommodative for so long.

A strong domestic currency affects the economy, achieving the same result as a tighter monetary policy. In addition, more tightening of monetary policy at a time when the domestic currency is already strong may exacerbate the problem by attracting hot money from foreign investors seeking higher productive investments.

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The Bottom Line

Like an iceberg, the major impact of exchange rates fluctuations lies beneath the surface. The indirect effect of currency fluctuations reduces the direct effect because of the huge influence it has on the economy in both the near term and long term. The indirect effect of exchange rates is extended to the prices you pay at the supermarket, the interest rates on your loans and savings, the returns on your investment portfolio, your job prospects, and possibly even on housing prices in your area.

Updated exchange rates of the Egyptian pound regarding different currencies

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