Why Do Foreign Exchange Rates Fluctuate?

Posted by Sonal Mistry on 8/16/21 11:58 AM

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To understand why foreign exchange rates fluctuate, you need to know a little about the economic principle of supply and demand, and how it relates to price. 

In most cases, the price of something - whether it is a commodity, product or service - is determined by the desire of others to buy it. The principle of supply and demand states that as demand increases, the supply of that commodity, product or service will decrease. As the supply decreases, prices will rise. The opposite is also true. 

How Do Currency Fluctuations Work?

Buying and selling foreign currency work along the same lines and according to the same principles, but things are slightly more complicated. 

The price of a given foreign currency is determined by more than the simple desire of others to buy it. There are a number of factors that affect the price of a country’s currency relative to another, including:

  • The monetary policy (money supply and interest rates) of the country in question
  • The rate of inflation of the domestic currency
  • The prevailing political and economic conditions, of both the country and the global system in which it exists
  • The levels of public debt 
  • Account deficits between nations

The foreign exchange rate (in other words, the prices of different national currencies valued against one another) fluctuate based on the laws of supply and demand, which are themselves affected by the factors listed above. 

A rising currency value is the result of high demand or a shortage of supply (and sometimes both). On the other hand, currency fluctuations that push a domestic currency price lower are the result of the opposite situation, with either a low demand, high supply, or some combination. 

Why is the Exchange Rate Important?

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Exchange rates, and the corresponding prices of national currencies, have a significant effect on the economies of every country in the world. 

If, for example, a national currency’s value is very high on the foreign exchange market, then that nation can benefit when importing goods. This is because each dollar of their currency is worth more on the market, so they can get better value when making purchases. So too can all of the businesses operating out of that country using that nation’s currency.

On the other hand, a highly valued currency has drawbacks for that nation as well, but this time, in the realm of exports. This is because when foreign interests (be they nations or foreign businesses) seek to make purchases on the open market, they may choose to avoid importing from you, as your nation’s higher comparative prices will cost them more in their own currency.

Because every nation has a vested interest in creating as much prosperity as possible for its citizens, national economic decision makers seek to stimulate their economies as much as possible, and manipulate the value of their own currencies so as to achieve their aims, balancing the pros and cons of higher and lower respective currency valuations.

How Can Foreign Currency Prices Affect the Health of Businesses and National Economies?

rising arrow on a graph indicating a healthy economy, with US dollars in the background

Foreign investors that want to buy a business’ goods or services will always try to get the best bang for their foreign capital buck. 

If the relative strength of the foreign currencies used to buy goods in your nation is weak, then you may find less interest in your products on the international market, as buyers flock to find better value elsewhere. 

On the other hand, if the value of a foreign currency is strong compared to your nation’s currency, then their purchasing power increases relative to yours, and there may be greater interest in your products, boosting your sales and stimulating your nation’s economy. 

Because flexible exchange rates respond to so many different factors, it can be difficult to navigate these waters and stay profitable, especially if the value of a currency you need to do business with fluctuates wildly. This kind of economic instability is bad for businesses, and is the reason that central banks attempt to balance the various factors that determine currency exchange rates.

How Can My Business Save Money in a World of Currency Fluctuations?

Any organization that sells commodities, products or services and needs to make payments to international suppliers requires a strategy to stay as profitable. The same goes for organizations buying commodities, products or services on the international market.

Luckily, there are companies like Olympia Trust that specialize in understanding and managing global payments for businesses at home and abroad, helping to mitigate the financial risks associated with foreign exchanges and currency fluctuations worldwide. 

The rate of exchange of currencies can have a severe negative impact on your balance sheet if not properly monitored and managed. A poor strategy related to the purchase or sale of foreign goods and services can reduce your overall purchasing power, and threaten the financial health of your company, and by extension, the financial health of your employees.

This is why Olympia Trust offers industry-specific currency and payment solutions for organizations of all sizes. To learn more about how they can help tailor their approach to your business and boost your bottom line, contact them today. They can help simplify what can sometimes seem like a complicated world of foreign exchange rates.

For Foreign Exchange Solutions, Work With Olympia Trust

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