## Why Do Currencies Fluctuate in Value? Analyzing the Nine Core Drivers Influencing the Forex Market

In the foreign exchange market, currency exchange rates are constantly changing. To understand the underlying logic, one must recognize that a country's currency fluctuations are not random but driven by multiple economic factors. Based on the time scale, these influencing factors can be categorized into three main groups: short-term market volatility factors (interest rates, market sentiment), medium-term economic fundamentals (inflation, unemployment rate, political risk, government debt, stock market performance), and long-term structural factors (trade conditions, fiscal policy).

### The Dual Engines of Short-Term Market Fluctuations: Interest Rates and Sentiment

**How Interest Rate Changes Rewrite Currency Attractiveness**

Central banks guide monetary policy by adjusting interest rates. An increase in interest rates means higher yields on assets denominated in that currency, attracting international capital inflows in exchange for the currency. When capital chases higher returns, demand for that currency rises, causing its exchange rate to strengthen. Conversely, lowering interest rates diminishes the currency’s investment appeal. The Reserve Bank of India once raised interest rates to counter the rupee’s depreciation pressure, exemplifying this mechanism.

**Self-Reinforcing Loop of Market Sentiment**

Market sentiment is the most difficult to quantify but has profound influence. When investors expect a currency to appreciate, their buying behavior can realize this expectation, further pushing up the exchange rate. During 2005-2006, the low interest rate environment in the US real estate market fostered optimistic expectations, leading to a rise in the dollar. This illustrates how investor psychology and market trends form a positive feedback loop.

### Medium-Term Factors Determining Economic Fundamentals

**Political Stability and Economic Growth Are Positively Correlated**

A stable political environment provides certainty for businesses and investors. When governments work to improve living standards and uphold the rule of law, economic growth momentum increases, boosting currency demand. The Brexit referendum serves as a negative example—on the day of the vote, the pound plummeted against the dollar, directly reflecting how political uncertainty can damage currency value.

**Inflation Rate: The Invisible Competition of Purchasing Power**

Inflation erodes a currency’s purchasing power; rational investors tend to favor currencies of countries with low inflation. If Country A’s inflation rate is significantly lower than Country B’s, A’s currency will appreciate over the long term because it retains more real value. Zimbabwe’s case is extreme—when hyperinflation soared to astronomical levels, the Zimbabwean dollar almost lost all appeal in the foreign exchange market, exemplifying a crisis of purchasing power.

**Growth Signals Behind Employment Data**

Employment rates are a barometer of economic health. High unemployment suggests economic stagnation, underutilized labor, and a mismatch between economic growth and population growth, ultimately leading to currency depreciation. Strong US non-farm payroll reports often drive the dollar index higher, as good employment data signals robust US economic momentum.

**Government Debt and Foreign Capital Attraction: An Inverse Relationship**

High national debt is akin to a company with heavy liabilities—foreign investors assess repayment risks. Countries with high debt levels face capital outflows, putting downward pressure on their currencies. When deciding whether to allocate funds to a country’s currency, investors observe long-term government debt trends. The weakness of the Indian rupee partly stems from persistent government debt that has not decreased proportionally with rising oil prices, affecting investor confidence.

**Market Sentiment as a Signal Light for Capital Markets**

A booming stock market reflects investor optimism about the future, and an upward trend in capital markets often leads to currency appreciation. Conversely, prolonged stock market declines signal bleak economic prospects, exerting downward pressure on the currency. The significant rise of China’s capital markets since 2005 mirrors the long-term appreciation trend of the renminbi, with the USD/CNY exchange rate moving lower accordingly.

### Long-Term Structural Factors That Determine Competitiveness

**Trade Conditions: The Advantage of Export Surplus**

Countries with strong exports tend to see their currencies appreciate over the long term. When exports exceed imports, foreign capital needs the local currency to purchase goods and assets, increasing demand. China’s sustained trade surplus has consistently supported its currency in the forex market. Conversely, countries with trade deficits face downward pressure on their currencies.

**Currency and Fiscal Policy as Systemic Attractors**

A government’s monetary and fiscal policy framework determines its attractiveness to foreign investment. If a government implements stable, transparent policies to attract foreign capital, investors will compete to hold that currency. This policy friendliness shapes long-term currency appreciation or depreciation trends.

### Holistic Perspective: From Factors to Action

Understanding these nine key variables is not only fundamental for forex trading but also essential for asset allocation. In the short term, interest rate changes and market sentiment dominate exchange rate fluctuations; in the medium term, economic fundamentals (inflation, employment, debt, stock market) set the direction; in the long term, trade competitiveness and policy frameworks solidify a currency’s position. For example, if Taiwan’s economic fundamentals are stable, its political environment is secure, and the central bank’s policies are supportive, the appreciation of the New Taiwan Dollar (NTD) will strengthen its position in regional forex markets, influencing the competitiveness of export-import companies and investors’ asset allocation decisions.

Mastering the interaction of these factors will enable you to more accurately predict forex market trends rather than passively follow market rises and falls.