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We all know that currencies fluctuate in value. A European vacationer in the US will be able to buy more for the same amount if dollar loses value against Euro. The opposite is also true. So, why does the value of a currency fluctuate? To answer this question, first we have to look at what a currency actually represents. A country's currency reflects the health of its economy. A strong and stable currency often represents a strong economy.
Supply and Demand
Currency prices, like all commodities, are determined by supply and demand. Currencies tend to gain value whenever its demand is greater than the available supply. It will become less valuable when its demand is less than the available supply. Reduced demand does not mean that people no longer want the money; it simply means they prefer holding their wealth in some other form. This other form can be gold, stocks, assets, or even some other currency.

Demand for a currency is due to both transaction demand and speculative demand for the currency. Transaction demand is directly related to a country's GDP and unemployment levels. These factors are influenced by political stability, natural disasters, and interest rates. GDP is a measure of the economic activity of a nation.

Speculative demand is not dictated by real transactions such as trade or finance. It is based on the speculation of the future value of a currency. For example, if oil is discovered in Jamaica, speculators would consider buying Jamaican dollar in large sums since they expect the country to grow rich in the future from the sale of oil. Thus the Jamaican dollar would gain value. However, it must be noted, that no real business activity is responsible for this increase. The oil is not yet being sold on the market. In general, the higher the interest rates, the greater the demand for a currency.

The exchange rate of a free-floating currency is allowed to vary against the rate of other currencies by the market forces of supply and demand. The value of a pegged currency is maintained by the government of the country at a fixed rate relative to some other currency.

Health of an Economy
Economic growth, interest rates, natural disasters and political stability affect the health of an economy. Investors want to invest in solid economies which are achieving steady growth. The best indicator for economic growth is the GDP. Higher GDP means higher growth rate of an economy.

Money tends to follow interest rates. If interest rates go up, money will flow into the country as investors seek to capitalize higher returns. Governments increase the money supply to stimulate economies. More money leads to lower interest rates, which in turn leads to an increase in demand for goods and services. Higher interest rates translate to reduced money supply which means increased demand for money. Increased demand results in increase of a currency's value.

Political turmoil, war, high unemployment and international conflict all scare investors. Who would want to invest in a country whose infrastructure could be destroyed in an expected war.

Natural disasters cause financial damage and disrupt economic activities. Reduced economic activities result in the reduction of GDP.

Both overvalued and undervalued currencies can help or hurt a nation's economy. Undervalued currency means that your products would be cheaper on the market, giving you a competitive advantage. An overvalued currency makes it more economical for a company to buy assets and invest in other countries where it would benefit from these investments in the future.

Factors that increase the value of a currency

fall in unemployment
rise in GDP
rise in exports
rise in interest rates
Factors that decrease the value of currency
rise in unemployment
fall in GDP
fall in exports
fall in interest rates
geo-political tensions
natural disasters
insecurity

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