The foreign exchange market is constantly changing, and with so much news coming in, it can be overwhelming, often leaving people unsure of where to start. Therefore, it is particularly important to understand the factors that influence exchange rate fluctuations.This article first analyzes the fundamental factors influencing exchange rate fluctuations based on exchange rate determination theory. Second, it examines key factors affecting exchange rate movements from the perspective that actual exchange rates in the foreign exchange market are determined by real supply and demand for foreign currency.
I. Analysis of the Fundamental Factors Affecting Exchange Rates Based on Exchange Rate Determination Theory:
1. Price Level.
According to the purchasing power parity theory, the equilibrium exchange rate between two countries is determined by their respective price levels. Therefore, when a country’s price level is relatively low, its exports will increase, the exchange rate will decline (direct quotation method, as below), and the domestic currency will appreciate.For example, a key reason for China’s long-term trade surplus is that the products it sells overseas are of high quality and low price, making them more competitive.
2. Changes in interest rates.
According to the interest rate parity theory, exchange rate fluctuations are influenced by the difference in interest rates between two countries. In essence, when a country’s interest rates are relatively low, the investment value of its domestic currency decreases, leading to capital outflows, an appreciation of the exchange rate, and a depreciation of the domestic currency.For example, when the Federal Reserve raises interest rates to curb domestic inflation, domestic interest rates rise, the investment value of the domestic currency increases, and the U.S. dollar appreciates. As shown in the figure below, the Federal Reserve’s rate hike in March 2022 led to higher interest rates, causing foreign capital to flow out of China, the U.S. dollar to appreciate, and the renminbi to depreciate.
3. National Income.
The balance of payments theory holds that exchange rates are determined by supply and demand in the foreign exchange market, which in turn is determined by the balance of payments. Any factor affecting the balance of payments will influence exchange rate fluctuations; changes in national income, price levels, interest rates, and expected exchange rates can all cause exchange rates to fluctuate.If a country’s national income rises, its imports will increase, demand for foreign exchange will rise, the exchange rate will appreciate, and the domestic currency will depreciate.
The above outlines several fundamental factors influencing exchange rate fluctuations. Based on the three major exchange rate determination theories—the purchasing power parity theory, the interest rate parity theory, and the balance of payments theory—this analysis examines the factors affecting exchange rate movements from various perspectives.However, actual exchange rates in the foreign exchange market are determined by real supply and demand for foreign currency, and the factors influencing this supply and demand are complex, encompassing economic, political, and psychological factors. Here, we will focus on a few key factors to illustrate their impact on exchange rate fluctuations.
II. Several Key Factors Affecting Actual Exchange Rate Fluctuations:
1. Level of economic development.
Economic conditions have a long-term and enduring impact on exchange rate fluctuations; in other words, fundamentals determine long-term trends.If a country has a strong economic foundation and robust future growth prospects, its currency will appreciate in the long run; while it may face setbacks in the short term due to certain factors, the overall trend will remain unchanged. Therefore, to analyze the long-term changes in a country’s exchange rate, one must first analyze its economic development.
2. The Impact of Political Factors.
Political factors are often sudden and difficult to predict, such as the enactment of policies or laws, political upheavals, or the outbreak of war. The more sudden a war is, the greater its impact on gold prices. If such events are anticipated, prices will reflect them in advance, and by the time they actually occur, the impact will be relatively minor. For example, the Russia-Ukraine conflict led to a sharp rise in international gold prices.As shown in the chart below, we can see that even before the war broke out—when tensions between Russia and Ukraine were high—prices reacted rapidly; however, once the conflict actually began, the price reaction was not as severe as it had been initially.
3. Psychological Factors.
The psychological expectations of foreign exchange market participants also influence exchange rate trends. The market often forms its own views regarding the appreciation or depreciation of a particular currency; once a certain consensus is reached, it will drive exchange rate fluctuations for a period of time. In such cases, exchange rates may rise or fall completely independently of fundamentals, or central bank interventions may prove ineffective.For example, when the majority of market participants expect an exchange rate to rise, the spot rate will rise accordingly.
Although the factors influencing the foreign exchange market are diverse and complex—and exert a significant impact on exchange rates—the market can change rapidly at the slightest sign of trouble.However, it is precisely this uncertainty that gives the foreign exchange market its value; uncertainty breeds expectations. Only by staying calm, filtering out the noise, and grasping the underlying logic of exchange rate movements can we emerge victorious in this game of strategic maneuvering.
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