Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. The exchange rate of one currency versus the other is influenced by numerous fundamental and technical factors. These include relative supply and demand of the two currencies, economic performance, outlook for inflation, interest rate differentials, capital flows, technical support and resistance levels, and so on. As these factors are generally in a state of perpetual flux, currency values fluctuate from one moment to the next. But although a currency's level is largely supposed to be determined by the underlying economy, the tables are often turned, as huge movements in a currency can dictate the economy's fortunes. In this situation, a currency becomes the tail that wags the dog, in a manner of speaking.
Currency Effects are Far-Reaching
While the impact of a currency's gyrations on an economy is far-reaching, most people do not pay particularly close attention to exchange rates because most of their business and transactions are conducted in their domestic currency. For the typical consumer, exchange rates only come into focus for occasional activities or transactions such as foreign travel, import payments or overseas remittances.
A common fallacy that most people harbor is that a strong domestic currency is a good thing, because it makes it cheaper to travel to Europe, for example, or to pay for an imported product. In reality, though, an unduly strong currency can exert a significant drag on the underlying economy over the long term, as entire industries are rendered uncompetitive and thousands of jobs are lost. And while consumers may disdain a weaker domestic currency because it makes cross-border shopping and overseas travel more expensive, a weak currency can actually result in more economic benefits.
The value of the domestic currency in the foreign exchange market is an important instrument in a central bank's toolkit, as well as a key consideration when it sets monetary policy. Directly or indirectly, therefore, currency levels affect a number of key economic variables. They may play a role in the interest rate you pay on your mortgage, the returns on your investment portfolio, the price of groceries in your local supermarket, and even your job prospects.
Currency Impact on the Economy
A currency's level has a direct impact on the following aspects of the economy:
Merchandise trade: This refers to a nation's international trade, or its exports and imports. In general terms, a weaker currency will stimulate exports and make imports more expensive, thereby decreasing a nation's trade deficit (or increasing surplus) over time.
A simple example will illustrate this concept. Assume you are a U.S. exporter who sold a million widgets at $10 each to a buyer in Europe two years ago, when the exchange rate was EUR 1=1.25 USD. The cost to your European buyer was therefore EUR 8 per widget. Your buyer is now negotiating a better price for a large order, and because the dollar has declined to 1.35 per euro, you can afford to give the buyer a price break while still clearing at least $10 per widget. Even if your new price is EUR 7.50, which amounts to a 6.25% discount from the previous price, your price in USD would be $10.13 at the current exchange rate. The depreciation in your domestic currency is the primary reason why your export business has remained competitive in international markets.
Conversely, a significantly stronger 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, industry sectors that are highly export-oriented can be decimated by an unduly strong currency.