What Causes Exchange Rate Fluctuations?

For firms that depend on export sales, or firms that rely on imported inputs to production, or even purely domestic firms that compete with firms tied into international trade—which in many countries adds up to half or more of a nation’s GDP—sharp movements in exchange rates can lead to dramatic changes in profits and losses. A central bank may desire to keep exchange rates from moving too much as part of providing a stable business climate, where firms can focus on productivity and innovation, not on reacting to exchange rate fluctuations.

One of the most economically destructive effects of exchange rate fluctuations can happen through the banking system. Financial institutions measure most international loans are measured in a few large currencies, like U.S. dollars, European euros, and Japanese yen. In countries that do not use these currencies, banks often borrow funds in the currencies of other countries, like U.S. dollars, but then lend in their own domestic currency.

Then the bank converts the dollars to its domestic currency.

The bank then lends the local currency to a firm in that location. The business repays the loan in baht, and the bank converts it back to U.S. dollars to pay off its original U.S. dollar loan.

This process of borrowing in a foreign currency and lending in a domestic currency can work just fine, as long as the exchange rate does not shift.

If, however the exchange rate changes in favor of the dollar, the dollar strengthens and the local currency weakens, a problem arises. Because of the shift in the exchange rate, the bank cannot repay its loan in U.S. dollars. (Of course, if the exchange rate had changed in the other direction, making the local currency stronger, the bank could have realized an unexpectedly large profit.)

Banks play a vital role in any economy in facilitating transactions and in making loans to firms and consumers. When most of a country’s largest banks become bankrupt simultaneously, a sharp decline in aggregate demand and a deep recession results. Since the main responsibilities of a central bank are to control the money supply and to ensure that the banking system is stable, a central bank must be concerned about whether large and unexpected exchange rate depreciation will drive most of the country’s existing banks into bankruptcy.