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Currency fluctuations are a natural outcome of floating exchange rates, which is the norm for most major economies. Numerous factors influence exchange rates, including a country's economic performance, the outlook for inflation, interest rate differentials, capital flows and so on. A currency's exchange rate is typically determined by the strength or weakness of the underlying economy. As such, a currency's value can fluctuate from one moment to the next.

KEY TAKEAWAYS

• Currency exchange rates can impact merchandise trade, economic growth, capital flows, inflation and interest rates.
• Examples of large currency moves impacting financial markets include the Asian Financial Crisis and the unwinding of the Japanese yen carry trade.
• Investors can benefit from a weak greenback by investing in overseas equities. A weaker dollar can boost their returns in U.S. dollar terms.
• Investors should hedge their foreign currency risk via instruments such as futures, forwards and options.

Effects Of Currency Fluctuations On The 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 for a strong domestic currency because that would make travel to Europe inexpensive. But the downside is a strong currency can exert 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.