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Anyone who has paid an energy bill or filled a gas tank in the U.S. over the last decade has likely noticed the rising cost of energy. While there are several forces at work, a very important factor is the declining value of the U.S. dollar. As the value of one’s domestic currency rises and falls relative to other foreign currencies, the impact can be expansive — from people’s wallets to the offices of the world’s central banks.
But what, exactly, causes a currency’s value to fluctuate? From the rate of inflation to monetary policy to political and economic conditions, there are many variables that shape a country’s currency value. But put simply, currency values fluctuate based on the laws of supply and demand.
Here are some of the key factors that impact supply and demand — and ultimately, a consumer’s purchasing power.
A country’s rate of inflation drives its interest rates. And interest rates tend to affect how international capital flows in and out of a country. “If inflation is consistently rising in any one country, the central bank is going to want to control that and they do that through raising interest rates,” says Brendan McGrath, CFA, corporate risk manager for Western Union Business Solutions.
Higher interest rates can stimulate the amount of foreign investors and their capital coming into the marketplace, causing the demand for the country’s currency to increase. Having a higher currency value then lowers the price of imported goods for citizens of that country.
“Interest rates for currencies are the main driving force behind a currency’s valuation,” McGrath says. “If people expect interest rates in a certain country to go up, it’s going to have a positive effect on that country’s currency.”
That movement of capital can also increase currency instability because foreign investors could stop investing at any time and withdraw their money, causing the foreign exchange value to quickly plummet. This has happened in countries like Brazil where foreign investors caused the currency value to increase when they invested in Brazilian companies in the early 2000s. This initially created a positive effect for Brazil, but now that foreign investors are withdrawing their money — causing a 40 percent drop in foreign investments in the first six months of 2012 — the government is slashing interest rates in the hopes of increasing cheaper loans and returning to its days of strong growth.
Many central banks attempt to manipulate demand for their currency by raising or lowering the benchmark interest rate — or the cost of borrowing currency — for reasons such as guarding against inflation or deflation, and maintaining a healthy economy.
For example, in 2011, the Japanese yen reached historical highs against all major foreign currencies, but then depreciated significantly in early 2012, after the Bank of Japan set an inflation target of 1 percent and expanded its asset-buying program.
A country’s economic and political conditions — including its policy on inflation and deflation, and gross domestic product (GDP) — can change a currency’s value and purchasing power. Factors such as weak employment conditions can hold back consumer spending, thereby driving down the value of a nation’s currency.
But sometimes, this scenario works in reverse, with the value of currency impacting economic and political conditions. “If the country is consumption-based, like the U.S., a depreciating currency can have a negative effect on employment,” McGrath says. “But the drop in the currency can also stimulate exports, which can help employment.”
This happened in Indonesia, when the country went from a currency deficit of nearly $5 billion in 1997 to a surplus of an estimated $3 billion in 1998, causing the Indonesian rupiah to rapidly depreciate. As the value of their money plummeted from June 1997 to May 1999 and inflation rates skyrocketed, it triggered food shortages, massive unemployment and widespread bankruptcy. This led to riots and social unrest during the spring of 1998.
“Anything that provides uncertainty, be it economic or political unrest, is going to have an effect on the currency, usually in a negative manner,” McGrath says.
Global tensions and political unrest make a country’s currency an unattractive investment option. Conversely, because the U.S. government has a strong history of stability, the U.S. dollar remains a popular currency within the global marketplace. “When tensions flare up or if there is a natural disaster, the U.S. dollar is seen as a safe haven and usually benefits from bad news,” McGrath says.
Whether an individual is dealing with a stable or volatile currency, it’s a good idea to put a plan in place and talk to trusted advisors to help mitigate possible risk. “Every currency is risky,” says an Analyst from Western Union Business Solutions. “While the U.S. dollar is more stable … there is still foreign exchange risk. The only question is who is holding it.”
 “The Rising Price of the Falling Dollar,” March 19, 2012, Forbes
 “Foreign Investments Fall 40% in Brazil,” Aug. 14, 2012, The Rio Times
 “World Economic Situation and Prospects 2012,” United Nations
 “The Impact of the Balance of Payments and Financial Crises on Indonesia’s Foreign Trade and Economic Performance,” August 1999, The International Centre for the Study of East Asian Development
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