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What factors contribute to the fluctuation of exchange rates?

In every currency transaction there are risks due to fluctuations on the realized value of such transfers. Many different factors contribute to the fluctuations of exchange rates. There are economic factors, political factors, and psychological factors to consider. Consumer driven supply and demand plays a part in the fluctuations that take place in the currency market. Another important contributing factor when dealing with foreign exchange rates is purchasing power parity, or PPP.

Economic, political, and psychological factors contribute to the fluctuation of exchange rates in a big way. The balance of payments, monetary and fiscal policy, inflation, real and nominal interest rates, government controls, and incentives are all economic factors that play a part in exchange rates. Contributing political factors include the philosophy of leaders and elections. Psychological factors affecting exchange rates can include expectations of the market, forward market prices, and traders' attitudes.

Supply and demand is a large contributing figure to fluctuation of exchange rates. By this I mean that the price of one currency in any other currency is the result of forces of supply and demand in the foreign exchange market.When one country's goods and/or services are in high demand, a short supply results. This allows the country to charge more for their goods and/or services, thereby increasing that country's economy and allowing the worth of that country's currency to increase in the foreign exchange market. So you have a fluctuation in exchange rates. Though supply and demand is an economic factor, it is such a major factor in the fluctuation of exchange rates that it deserves separate mention.

Another major contributing factor to the fluctuation of exchange rates is the purchasing power parity, or PPP. PPP is important to take into account when forecasting exchange rates. Basically, purchasing power parity means that one unit of currency should buy the same amount of goods and services as it bought in an equilibrium period, despite differential rates of inflation. Consequently, a lower level of inflation would equal a rise in the PPP effect. The formula for calculating the PPP impact is: S (+1=(S ()x1+i (/1+i (. In this formula, S is the spot rate of exchange in the number of units of the home currency equal to one unit of the foreign currency, i ( is the inflation rate of in the home country, i ( is the inflation rate in the foreign country, ( is the base period or the….....