Exchange Rate Dynamics & Fluctuations

Part 1: What Are Exchange Rates?

An exchange rate is essentially the price of one currency in terms of another. For example:

Direct quote: 1 USD = 83 INR → How many rupees per dollar.

Indirect quote: 1 INR = 0.012 USD → How many dollars per rupee.

Functions of Exchange Rates

Facilitate international trade – exporters and importers settle payments.

Enable cross-border investment – FDI, FIIs, bonds, equity markets.

Act as indicators of competitiveness – strong vs weak currency matters for exports.

Transmit global shocks – inflation, oil prices, interest rate changes often flow through currency movements.

Part 2: Exchange Rate Systems

Countries adopt different systems to manage their currencies:

Fixed Exchange Rate System

Currency pegged to gold or another currency (e.g., Bretton Woods system).

Provides stability but reduces flexibility.

Floating Exchange Rate System

Currency value determined purely by demand and supply in forex markets.

More volatile but allows automatic adjustment.

Managed Floating (Dirty Float)

Combination of both: central banks intervene occasionally to prevent extreme volatility.

Example: India’s rupee is a managed float.

Currency Pegs & Boards

Some countries peg their currencies to the US dollar or euro (e.g., Hong Kong dollar).

Offers stability but imports inflation/monetary policy from the anchor country.

Part 3: Theories of Exchange Rate Determination

Economists have proposed several models to explain exchange rate movements:

Purchasing Power Parity (PPP)

Currencies adjust to equalize the purchasing power of different countries.

Example: If a burger costs $5 in the US and ₹400 in India, then PPP exchange rate = 400/5 = 80.

Interest Rate Parity (IRP)

Interest rate differences between countries affect forward exchange rates.

Higher interest rates attract capital inflows, strengthening the currency.

Balance of Payments Approach

Exchange rate depends on trade balance (exports-imports) and capital flows.

Trade surplus strengthens currency; deficit weakens it.

Monetary Approach

Currency value linked to money supply and inflation.

Higher inflation depreciates a currency.

Asset Market Approach

Exchange rate determined by demand and supply of financial assets across countries.

Part 4: Key Drivers of Exchange Rate Fluctuations
1. Demand and Supply of Currencies

Like any commodity, exchange rates are influenced by demand and supply. If more people want dollars (for oil imports, for example), the dollar strengthens.

2. Interest Rates

High domestic interest rates attract foreign capital → appreciation of the local currency.
Low interest rates cause outflows → depreciation.

3. Inflation Rates

Countries with lower inflation rates tend to see currency appreciation, as purchasing power is preserved.

4. Trade Balance

Export surplus → stronger currency.

Import-heavy economy → weaker currency.

5. Foreign Direct Investment (FDI) and Portfolio Flows

When investors buy stocks, bonds, or companies in a country, they demand that country’s currency → appreciation.

6. Speculation and Market Sentiment

Traders often buy or sell currencies based on expectations. If markets expect the rupee to fall, speculative selling accelerates the decline.

7. Central Bank Intervention

Central banks sometimes buy/sell foreign currencies to stabilize their domestic currency.
Example: RBI selling dollars to support the rupee.

8. Geopolitical Events and Political Stability

Wars, elections, coups, and policy changes can trigger sharp movements.

9. Commodity Prices

Oil-exporting nations’ currencies (like Russia’s ruble) rise when oil prices rise.
Oil-importing countries (like India) see their currency weaken when oil becomes expensive.

10. Global Risk Appetite

During crises, investors flock to “safe haven” currencies (USD, CHF, JPY), causing them to appreciate.

Part 5: Types of Exchange Rate Fluctuations

Appreciation – Currency value rises (e.g., USD/INR falls from 83 → 80).

Depreciation – Currency value falls (e.g., USD/INR rises from 83 → 86).

Devaluation – Government/central bank officially reduces the currency’s value under fixed system.

Revaluation – Official increase in value.

Volatility – Short-term fluctuations due to speculative trading, news, or shocks.

Part 6: Real-World Examples

Asian Financial Crisis (1997)

Thai baht collapse spread across Asia.

Triggered by excessive borrowing and weak reserves.

Eurozone Debt Crisis (2010–12)

Euro weakened due to fears of Greek and other sovereign defaults.

COVID-19 Pandemic (2020)

Investors rushed into the dollar as a safe haven.

Emerging market currencies depreciated sharply.

Russia-Ukraine War (2022)

Ruble crashed initially, then recovered after capital controls and oil exports.

Indian Rupee Movements

1991 crisis forced devaluation.

2008 crisis → rupee fell due to capital outflows.

Recent years: rupee under pressure due to oil imports and strong US dollar.

Part 7: Implications of Exchange Rate Fluctuations
1. On Trade

A weaker currency makes exports cheaper, boosting demand abroad.

But it makes imports more expensive, adding inflationary pressure.

2. On Inflation

Import-dependent economies (like India with oil) see higher inflation when their currency depreciates.

3. On Investment

FIIs gain/loss depends on both stock performance and currency movement.

Currency depreciation can wipe out returns.

4. On Government Policy

Central banks adjust interest rates, intervene in forex markets, and build reserves.

5. On Common People

Travelers, students abroad, NRIs, and businesses all feel the effect of currency changes.

Part 8: Managing Exchange Rate Risk

Hedging with Derivatives

Forwards, futures, options, and swaps help companies lock in exchange rates.

Natural Hedging

Matching foreign currency revenues with expenses.

Diversification

Spreading trade and investments across multiple currencies.

Government Policies

Building forex reserves, imposing capital controls, or adjusting interest rates.

Part 9: The Future of Exchange Rate Dynamics

Digital Currencies

Central Bank Digital Currencies (CBDCs) may change cross-border payments.

Geopolitical Realignment

De-dollarization attempts by BRICS could alter forex dynamics.

Climate & Commodity Shocks

Weather events affecting agriculture and energy may impact currencies.

AI & Algorithmic Trading

High-frequency forex trading will increase volatility.

Conclusion

Exchange rate dynamics and fluctuations are at the heart of the global economy. They result from a complex interplay of trade, investment, inflation, interest rates, speculation, and geopolitics. No single factor explains all movements—currencies reflect the combined pulse of global markets.

For policymakers, managing exchange rates is a balancing act between stability and flexibility. For businesses, it’s a constant risk to hedge against. For investors, it’s both a challenge and an opportunity.

Ultimately, exchange rates are more than numbers—they represent the relative strength, stability, and future expectations of nations in the interconnected global system.