Direct Impact of Currency Fluctuations on the Economy
As highlighted, currency fluctuations have both a direct and indirect impact. Former is seen in terms of numbers, charts, and trends in an economy on a macro-level in the following ways:
1. Foreign Trade
As discussed before, a weaker currency makes imports expensive for your country while the stimulation of exports becomes cheaper. This directly impacts a nation’s trade deficit or trade surplus over time.
For example, assume you are an Indian exporter who sells clothes at INR 500 each to a buyer in the US. The exchange rate is Rs. 70 = USD 1. Therefore, the cost to your US buyer is USD 7.14 per cloth.
Now let’s say the rupee weakens, and the exchange rate is Rs. 77= USD 1. Even if prices are negotiated, you will still be clearing more than before from the sale. A weak Indian rupee allows your export business to remain competitive in international markets.
Conversely, a stronger currency can widen the trade deficit and reduce export competitiveness, damaging export-dependent industries. While eventually, the currency will weaken in a self-adjusting mechanism, the damage would be done, impacting the economy severely and lowering the value of a nation’s GDP.
Related Article – Difference and Relationship Between Foreign Trade and Foreign Investment
2. Foreign Capital
Stronger the government, the more viable the dynamicity of the economy, and the more stable the currency, the more the inflow of foreign capital from investors. Currency fluctuations first deter overseas investors before impacting others.
Governments prefer FDI (foreign direct investment, where investors take stakes in existing companies) over Foreign portfolio investment (investors trade securities) since the latter leaves faster when currency fluctuates. Despite this, capital flights happen when conditions grow tough.
3. Country’s Inflation
Let’s go back to the example from point 1.
With a weaker currency, exporters were happy but what about the importers? They now have to pay more for imported goods, which impacts the price they will sell into the domestic markets. Hence, a devalued currency may cause “imported” inflation for countries with substantial importers.
4. Prevailing Interest Rates
Now, extending from point 3, the inflation rate is pushed in a nation that is a big importer; to counter the inflation rate and prevent the currency from plunging sharply, the central bank will raise interest rates, tightening the monetary policy. Conversely, a strong currency depressing inflation rates will exert a drag on the economy, where any tightening of the monetary policy at a time of strong domestic currency will attract foreign investors seeking higher-yielding investments (which would further strengthen the domestic currency).
Currency Fluctuations and Its Impact on the Economy
Now and then, you keep reading about the currency fluctuations, especially given the current economic and political conditions; it seems to be hitting all-time highs or lows. Recently, the Indian rupee hit 83.3 against the $1 US dollar.
You know that currency is normally seen from the lens of exchange rates. In today’s era of globalization, the trading of goods and services is more common than ever between countries. And exchange rates define the price you pay for buying products from other countries. In this article, we’ll cover what currency fluctuation is and how it impacts the economy.