Currency Fluctuations: How they Affect the Economy (2024)

Currency fluctuations can have wide-ranging impacts on the economy. A natural outcome of floating exchange rates, they can affect commerce, economic growth, capital flows, inflation, interest rates, and beyond.

A currency's exchange rate is typically determined by the strength or weakness of the underlying economy.

Far-Reaching Currency Impacts

Many people do not pay attention to exchange rates because rarely do they need to. The typical person's daily life is conducted in their domestic currency. Exchange rates only come into focus for occasional transactions, such as foreign travel, import payments, or overseas remittances.

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

The value of the domestic currency in the foreign exchange market is a key consideration for central banks when they set monetary policy. Directly or indirectly, currency levels may play a role in the interest rate you pay on your mortgage, the returns on your investment portfolio, the price of groceries at your local supermarket, and even your job prospects.

Currency Impact on the Economy

A currency's level directly impacts the economy in the following ways:

Merchandise Trade

This refers to a nation's imports and exports. In general, a weaker currency makes imports more expensive, while stimulating exports by making them cheaper for overseas customers to buy. A weak or strong currency can contribute to a nation's trade deficit or trade surplus over time.

For example, assume you are a U.S. exporter who sells widgets at $10 each to a buyer in Europe. The exchange rate is €1=$1.25. Therefore, the cost to your European buyer is €8 per widget.

Now let's say the dollar weakens and the exchange rate is €1=$1.35. Your buyer wants to negotiate a better price, and you can afford to give them a break while still clearing at least $10 per widget. Even if you set the new price at €7.50 per widget, which is a 6.25% discount from your buyer's perspective, your price in dollars is $10.13 at the current exchange rate. A weak U.S. dollar allows your export business to remain competitive in international markets.

Conversely, a 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, export-dependent industries can be damaged by an unduly strong currency.

Economic Growth

The basic formula for an economy’s GDP is:

$\begin{aligned} &GDP= C + I + G + (X-M)\\ &\textbf{where:}\\ &\begin{aligned} C = &\text{ Consumption or consumer spending, the biggest}\\ &\text{ component of an economy}\end{aligned}\\ &I = \text{Capital investment by businesses and households}\\ &G = \text{Government spending}\\ &(X-M) = \text{Exports}- \text{Imports, or net exports}\\ \end{aligned}$​GDP=C+I+G+(X−M)where:C=​Consumptionorconsumerspending,thebiggest​I=CapitalinvestmentbybusinessesandhouseholdsG=Governmentspending(X−M)=Exports−Imports,ornetexports​

From this equation, it is clear that the higher the value of net exports, the higher a nation's GDP. As discussed earlier, net exports have an inverse correlation with the strength of the domestic currency.

Capital Flows

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

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

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

Inflation

A devalued currency can result in "imported" inflation for countries that are substantial importers. A sudden 20% decline in the domestic currency could result in imports costing 25% more, as a 20% decline means a 25% increase is needed to get back to the original price point.

Interest Rates

As mentioned earlier, exchange rates are a key consideration for most central banks when setting monetary policy. A strong domestic currency exerts a drag on the economy, achieving the same result as a tighter monetary policy (i.e. higher interest rates). In addition, further 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-yielding investments (which would further strengthen the domestic currency).

Global Impact of Currency Fluctuations

The forex market is the most actively traded market in the world, with an excess of more than $5 trillion traded daily, far exceeding global equities. Despite such enormous trading volumes, currencies usually stay off the front pages.

However, there are times when currencies move in dramatic fashion and the reverberations are felt around the world. We list below a few examples:

The Asian Financial Crisis of 1997-98

A prime example of the havoc caused by adverse currency moves is the Asian Financial Crisis, which began with the devaluation of the Thai baht in the summer of 1997. The devaluation occurred after the baht came under intense speculative attack, forcing Thailand's central bank to abandon its peg to the U.S. dollar and float the currency. This currency contagion spread to neighboring countries such as Indonesia, Malaysia, and South Korea, leading to a severe contraction in these economies as bankruptcies soared and stock markets plunged.

Japanese Yen's Gyrations (2008 to Mid-2013)

The Japanese yen was one of the most volatile currencies between 2008 and 2013. Because of Japan's policy of near zero-bound interest rates, traders favored the yen for carry trades, in which they borrowed yen for next to nothing and invested in higher yielding overseas assets. But as the global credit crunch intensified in 2008, the yen began appreciating sharply as panicked investors bought the currency in droves to repay yen-denominated loans.

As a result, the yen appreciated by more than 25% against the U.S. dollar in the five months to January 2009. Then in 2013, Prime Minister Shinzo Abe unveiled monetary stimulus and fiscal stimulus plans (nicknamed "Abenomics") that led to a 16% plunge in the yen within the first five months of the year.

Euro Fears (2010-12)

Concerns that the deeply indebted nations of Greece, Portugal, Spain, and Italy would be forced out of the European Union led the euro to plunge 20% from 1.51 to the dollar in December 2009 to about 1.19 in June 2010. The euro recovered its strength over the next year, but that only proved temporary. A resurgence of EU break-up fears led to a 19% slump in the euro from May 2011 to July 2012.

How Investors Can Hedge

Invest Overseas

US-based investors who believe the greenback is weakening should invest in strong overseas markets, because their returns will be boosted by foreign currency gains.

Invest in U.S. Multinationals

The U.S. has many large multinational companies that derive a substantial part of revenues andearnings from foreign countries. Earnings of U.S. multinationals are boosted by the weaker dollar, which should translate into higher stock prices when the greenback is weak.

Refrain From Borrowing in Low-Interest Foreign Currencies

Never borrow in a foreign currency if it is liable to appreciate and you do not understand or cannot hedge the exchange risk.

Hedge Currency Risk

Adverse currency moves can significantly impact your finances, especially if you have substantial forex exposure. But there are plenty of choices to hedge currency risk, such as currency futures, currency forwards, currency options, and exchange-traded funds.

The Bottom Line

Currency moves can have a wide-ranging impact on the domestic economy and globally as well. When the greenback is weak, investors can take advantage by investing overseas or in U.S. multinationals. Because currency moves can be a potent risk when one has a large forex exposure, it may be best to hedge this risk through the many hedging instruments available.