Causes of exchange rate fluctuations

There are several approaches to explaining the causes of exchange rate fluctuations

· Balance of payments

· Purchasing power parity theory

· Interest rate parity.

Balance of payments

The balance of payments is defined here as the difference between the value of a country’s exports in goods and services and the value of its imports in goods and services. A balance of payments is in surplus when exports exceed imports, and is in deficit when imports exceed exports.

In the principle, the balance of payments should affect the value of a country’s currency in the foreign currency markets.

In theory (but not in practice) the value of currencies should change to the point where balance of payments surpluses and deficits are eliminated. This is because of capital movements between countries.

Capital movements can be very large. As a result, exchange rates movements that should be expected as a consequence of a balance of payments surplus of deficit might not happen.

At the time of writing, for example, the USA has a very large balance of payments deficit. However, the value of US dollar is sustained, and kept higher than it would otherwise be, by a willingness of investors in other countries to hold US dollar-denominated investments.

Purchasing power party

This theory is based on the assumption that the exchange rate will adjust to enable the same amount of goods to be purchased in any country with a given amount of money. This theory relies on the assumption of no trade barriers and internal price flexibility.

The theory therefore predicts that if inflation is high the exchange rate will fall to restore purchasing power parity. In reality this may not occur in the short run due to:

· Trade barriers

· Non-price competition

· The impact of interest rates on capital flows

Interest rate parity theory

This theory is based on the assumption that exchange rates will adjust to eliminate differences in interest rates between countries.