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7 Reasons Why Currency Exchange Rates Fluctuate

Forex trading is more like a roller coaster today. Exchange rates continue changing making some currencies hit their highest highs while others reach the bottom to hit the lowest low. As a result, we can see the value of currency falling or rising continuously. This involves even some major currency pairs.

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It appears that there is no indicator that can clearly predict or identify the fluctuation. For this reason, to understand how to transform your trading strategies in case of unexpected moves, you need to understand the factors or reasons why exchange rates fluctuate.

Why Do Currencies Fluctuate?

As a forex trader, you probably know that the majority of currencies come with a floating exchange rate. Experts sometimes call it a flexible rate. In simpler words, it means that the exchange rate of the underlying asset fluctuates depending on its supply and demand in the foreign exchange.

These are the two main factors that we need to consider to start Forex trading. At the same time, other factors may also have either a negative or positive influence on the foreign currency exchange rate. So, let’s have a more detailed look at each of them.

1. Currency Supply

The supply defines the amount of currency available for trading. When the asset comes with a growing supply, it also loses its value. Many beginners think central banks are responsible for controlling the currency supply.

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Well, it is true in the perfect world. In reality, many other factors can increase or reduce the supply. Some traders artificially increase it to reduce the value of the given instrument they trade. The same can happen when the market is under oversold conditions.

2. Currency Demand

The demand describes the volume of the asset traders are eager to buy at this very moment. This is where we can see the opposite influence of an instrument and changes in demand. If it rises and more traders want to buy the asset, the higher value it will have.

Additional Factors that Make Currency Exchange Rate Fluctuate

Supply and demand are not the only reasons for currency rates to fluctuate. Central banks can interfere with the Forex market to improve the economic situation. Internal and external economic factors may also have either negative or positive effects including geopolitical situations, news, etc.

So, here are additional reasons to take into account when speaking about currency rate fluctuation.

Inflation Rate

Although it is not directly connected with the exchange rate, inflation is one of the main reasons for the national currency to fluctuate. Inflation determines how expensive goods and services will be for the population.

Moderate inflation is a sign of a healthy and stable economy. When it goes too high, it makes the currency extremely vulnerable. The asset starts losing its value. This is where central banks interfere and take some actions to keep the situation under control.

Central Banks

Central banks represent ‘national institutions with the mission to keep the financial system stable and keep the value of the national currency protected. To do so, central banks have different means and tools to apply if something goes wrong:

  • Monetary policy – an instrument to stimulate the national economy. It is used to help central banks establish control over the currency supply and demand (control the circulation of the currency). Additionally, monetary policy is a tool to benchmark interest rates.
  • Central bank rate – experts call it the federal fund rate. This tool makes it possible for the government to manage domestic economic activities. Generally, the rate is set taking into account the situation inside the country to either decrease or increase economic activity.
  • Open Market Operations – also known as OMO, the instrument introduces the process of buying or selling bonds, stocks, etc. The government enters the open market to actually trade different securities.

International Trading

The increase in export prices means a favorable economic situation for the country, especially if it rises faster compared to the import prices. It leads to higher country’s revenues and a healthier and stronger currency which has a higher value.

National Debt

Sometimes, the government needs extra funds to support the launch of some new projects or update the existing ones. The only way for it to get needed capital is to borrow money, especially when the political and economic situation is worsening. Such actions may lead to an inflated economy. To pay back, the government will likely print more cash to cover the debt. This will negatively affect the national currency exchange rate making the asset value decrease.

Economic and Political Health

The currency fluctuation may take place due to continuously changing economic and political circumstances inside the country. If the nation is facing a crisis (either political or economic), people will loom for a safer place to keep their savings.

The national currency is no longer appealing to them as it does not look safe in the long-term perspective. This is why major currency pairs are formed by assets from economically and politically stable and healthy countries. This is why they have the highest exchange rate.

The Bottom Line

Currency exchange rate fluctuation can be the result of different actions taken by either central banks or traders. Additionally, we should take into account the overall economic and political situation. The bad news for traders here is that there is no Forex indicator to clearly explain why the currency fluctuates.

So, one will need to rely on fundamental analysis instead of technical. The more insider information you have about the nation’s economic potential as well as factors that may somehow affect the supply and demand, the more accurate predictions you can make.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.