Exchange rates are relative prices. They state how many units of one currency are required to obtain a unit of another. When the euro appreciates against the dollar, it means a euro buys more dollars than before. The question of why exchange rates change is a question about what shifts the supply of and demand for currencies, how those shifts are transmitted through the global foreign exchange market, and why the equilibrium price moves over time.
Understanding these movements requires linking macroeconomic fundamentals, institutional arrangements, and market microstructure. The explanations differ across horizons. Over minutes and days, news surprises and order flow dominate. Over months and years, differences in inflation, productivity, policy credibility, and external balances tend to matter more. No single factor explains every episode, but the logic of relative prices provides a consistent framework.
What We Mean by Exchange Rate Changes
An exchange rate can be quoted in various forms. A bilateral spot rate is the current price for immediate exchange, such as USD per EUR. A forward rate is an agreed price today for exchange at a future date, which embeds interest rate differentials. Nominal exchange rates are expressed in currency units. Real exchange rates adjust the nominal rate by relative price levels to reflect the price of goods and services across countries.
When we say a currency appreciated, we mean it gained value relative to another. Depreciation means it lost value. Under fixed or managed regimes, authorities sometimes devalue or revalue the currency by changing the official parity. In a floating regime, prices move continuously in response to market forces.
How Exchange Rates Fit into the Market Structure
The foreign exchange market is a decentralized, over-the-counter network. Large banks, electronic market makers, hedge funds, asset managers, corporations, and central banks transact around the clock across major financial centers. There is no single exchange. Liquidity concentrates on electronic platforms and interdealer venues, with quotes paired by currency and maturity.
Prices are discovered through continuous two-way quoting. Dealers post a bid and an ask, and adjust quotes as orders arrive and information updates. At the micro level, exchange rates move because buy and sell orders are not perfectly balanced. Order flow transmits information from dispersed traders to the price. At the macro level, the pattern of orders reflects expectations about growth, inflation, policy, and risk, as well as the transactional needs of trade and investment.
Because FX is used to settle cross-border payments, the market links the real economy to financial portfolios. Importers, exporters, borrowers, and investors all create currency demand and supply. The market clears at the exchange rate that equates these flows at each moment.
Core Economic Drivers
Relative Interest Rates and Monetary Policy
Interest rate differentials are a central driver of currency values. When a country’s policy rate rises relative to others, its short-term yields tend to become more attractive. All else equal, this can increase demand for its currency as investors require that currency to hold its interest-bearing assets. Forward exchange rates embed these differentials through covered interest parity, while expected future differentials influence spot rates through uncovered parity in theory.
Monetary policy affects more than yields. Central banks influence expectations about inflation and growth, adjust the size and composition of their balance sheets, and provide signals about policy paths. A credible tightening that convinces markets inflation will be contained can support a currency by boosting real expected returns. A rate increase that markets read as a response to deteriorating fundamentals can have a weaker or even opposite effect.
Example. In 2022, several advanced economies raised policy rates rapidly to address high inflation. The currencies of economies that moved earlier and signaled persistent restraint often strengthened against peers, not simply because rates were higher but because the expected real policy stance and credibility were perceived to be firmer.
Inflation Differentials and Purchasing Power
Over longer horizons, currencies tend to reflect relative price levels. If one country’s prices rise faster than another’s, the goods and services produced there become relatively more expensive. To restore competitiveness, the currency with higher inflation often depreciates. This is the intuition behind purchasing power parity. PPP is not a precise short-run rule, but persistent inflation gaps usually show up in the exchange rate over time.
Example. In the late 1980s and early 1990s, several high-inflation emerging economies experienced gradual depreciation against the currencies of lower-inflation trading partners. When domestic inflation slowed toward international norms, their exchange rates typically stabilized or appreciated in real terms.
Growth, Productivity, and Income Effects
Faster productivity growth can support a stronger currency by raising expected future incomes and returns. The Balassa-Samuelson mechanism provides one pathway. Productivity gains in tradable sectors push up wages economy-wide, which lifts prices in nontradable sectors. The relative price shift shows up as real appreciation. Investors also revalue assets when a country’s technology or demographic outlook improves.
However, strong growth associated with overheating pressures, widening external deficits, or policy uncertainty may not support the currency. The exchange rate reflects the quality and sustainability of growth, not only its pace.
Example. The rapid expansion of some Central and Eastern European economies before the global financial crisis coincided with real exchange rate appreciation driven by productivity catch-up. Where credit booms outpaced fundamentals, later corrections were sharp.
Trade Balances, Current Accounts, and External Adjustment
The current account records trade in goods and services plus net income and transfers. A deficit means a country absorbs more than it produces and must attract foreign capital to finance the difference. A surplus means the country is a net lender to the rest of the world. Exchange rates adjust to facilitate these flows. A persistent deficit often places downward pressure on the currency to make exports cheaper and imports more expensive, which helps narrow the gap. A surplus can create the opposite tendency.
The speed of adjustment depends on elasticities of trade and the composition of flows. Economies with price-sensitive exports may see faster responses of volumes to currency changes than those that export specialized capital goods or commodities priced in dollars.
Example. After the Asian financial crisis in 1997 to 1998, several economies moved from deficits to surpluses. Significant currency depreciation improved competitiveness and aided external adjustment, although the process was also influenced by financial restructurings and policy reforms.
Capital Flows and Portfolio Preferences
Portfolio rebalancing can move exchange rates quickly. When global investors increase allocations to a country’s bonds or equities, they must obtain the local currency to settle purchases. Conversely, outflows require selling the currency. Shifts in risk appetite, benchmark index changes, and regulatory adjustments can induce large flows independent of near-term trade.
Foreign direct investment tends to be more stable, but mergers and acquisitions, privatizations, and large infrastructure projects can generate sizable currency demand or supply at specific times. The structure of a country’s investor base and its net foreign asset position influence how sensitive the currency is to these portfolio decisions.
Example. During the 2013 tapering episode in the United States, expectations of reduced asset purchases coincided with portfolio outflows from several emerging markets. Their currencies depreciated as investors reassessed relative yields and risks.
Terms of Trade and Commodity Prices
For commodity exporters and importers, global price swings affect trade income and often the exchange rate. When a key export commodity rises in price, the exporter’s terms of trade improve. Revenues increase for a given volume, which can strengthen the currency through higher export receipts and improved external balances. When prices fall, the opposite can occur.
Example. Oil price declines in 2014 to 2016 placed downward pressure on the currencies of oil exporters such as Canada, Norway, and Russia, while improving the external position of large importers. The magnitude of currency moves varied with hedging, fiscal buffers, and monetary responses.
Risk Sentiment and Safe-Haven Behavior
In periods of market stress, investors often seek assets perceived as safer or more liquid. Currencies associated with deep, transparent financial markets and credible institutions may appreciate as capital rotates toward them. In calmer periods, flows may favor higher-yielding or faster-growing markets. These patterns are not mechanical and can reverse when conditions change.
Example. During the acute phase of the 2008 global financial crisis, demand for dollar liquidity surged. The dollar appreciated against many currencies even though the United States economy was contracting, reflecting the central role of the dollar in global funding and settlement.
Policy Credibility, Institutions, and Political Risk
Sound and predictable institutions help anchor exchange rates by shaping expectations. Sudden policy shifts, capital controls, fiscal slippages, and political uncertainty can trigger reassessments of risk and value. The same macro variables can have very different currency effects depending on the credibility of the policy framework that accompanies them.
Example. Announcements of unexpected referendums, contested election outcomes, or abrupt regulatory changes have at times produced sharp currency moves. The 2016 United Kingdom referendum result led to a rapid depreciation of sterling as investors recalibrated expectations for trade, investment, and policy trajectories.
Central Bank Intervention and Balance Sheet Policies
Authorities sometimes buy or sell foreign currency to influence the exchange rate or to maintain a target range. In fixed or managed regimes, intervention is a core tool. Interventions can be sterilized, offsetting their impact on domestic liquidity, or unsterilized, allowing money supply to change. Effectiveness depends on credibility, the stock of reserves, and whether intervention signals future policy.
Quantitative easing and other balance sheet policies can affect exchange rates by altering the supply of safe assets and term premiums. When a central bank purchases long-term bonds, it can lower domestic yields relative to foreign yields, which may weaken the currency, although the net effect depends on growth and inflation expectations as well.
Example. The Swiss National Bank maintained a floor for EUR/CHF from 2011 to early 2015 through large-scale purchases of foreign currency. When the floor was discontinued, the franc appreciated sharply as the constraint was removed and market prices adjusted to new expectations.
Market Microstructure, Liquidity, and Order Flow
Short-horizon exchange rate changes often arise from liquidity conditions rather than shifts in fundamentals. Bid-ask spreads widen or narrow with market depth, and time-of-day effects around major market opens and closes can amplify moves. Concentrated order flow from large hedging programs, corporate deals, or rebalancing at month-end fixings can push prices temporarily.
Unexpected news releases create price gaps as market makers update quotes to manage inventory risk. In thin markets, even modest orders can move prices. These microstructure effects are part of how information becomes embedded in the exchange rate.
Short Run and Long Run: Distinguishing Horizons
It is useful to separate near-term volatility from persistent trends. Over minutes and hours, prices can overshoot as traders and algorithms react to data that surprise consensus expectations. Over months and years, forces like inflation differentials and productivity trends gradually exert influence. Economic theory captures this with concepts such as sticky prices and imperfect information, which allow nominal rates to move quickly while goods prices adjust more slowly.
This distinction helps explain why currencies sometimes appreciate after a weak data release or depreciate after a rate hike. The surprise component relative to prior expectations often drives the immediate move, while the underlying fundamentals shape the medium-term path.
Exchange Rate Regimes and Their Implications
Exchange rates change within institutional contexts known as regimes. The main categories are:
- Free float. Market forces determine the rate. Authorities may reserve the right to intervene, but there is no announced target.
- Managed float. Authorities guide the rate within broad ranges through discretionary intervention or macroprudential tools.
- Fixed or pegged. The currency is tied to another currency or basket at a set parity. A currency board is a hard form of peg backed by foreign reserves.
- Crawling or adjustable peg. The parity adjusts periodically according to a rule or discretion.
Under a float, prices move continuously and often by small increments. Under a peg, the central bank absorbs pressure by buying or selling reserves. When pressures exceed available buffers or policy tolerance, authorities may devalue or revalue. Regime choice affects how other drivers translate into exchange rate changes.
Balance of Payments Logic
The balance of payments provides a useful accounting identity. The current account plus the capital and financial account plus errors and omissions sums to zero. If a country runs a current account deficit, it must attract an equal capital inflow. If it runs a surplus, it must export capital. The exchange rate is the price that helps equilibrate these flows. When desired capital inflows fall short of what is needed to finance a deficit, the currency tends to depreciate until either the deficit narrows or inflows resume. The identity does not predict timing, but it frames the adjustment mechanism.
Measuring Exchange Rate Changes
There are several useful measures beyond a single bilateral rate:
- Nominal effective exchange rate. A trade-weighted index of the currency against major partners. It reflects the broader competitive position.
- Real effective exchange rate. The nominal effective rate adjusted for relative inflation. It provides a gauge of price competitiveness across partners.
- Spot versus forward. Spot rates reflect current prices. Forward rates incorporate interest differentials and expectations about future conditions.
Interpreting moves across these measures helps separate changes driven by a single bilateral relationship from changes that reflect a general shift in the currency’s global value.
News, Expectations, and Data Surprises
FX prices embed expectations. Economic data, policy announcements, and geopolitical events move exchange rates when they differ from what was anticipated. A payroll report that beats consensus, an inflation print below forecasts, or a central bank statement that changes guidance can all trigger immediate moves. The surprise component often matters more than the level of the data itself.
Professional forecasters and market-implied measures provide baselines for expectations. When outcomes deviate from those baselines, prices adjust rapidly as participants update beliefs about future interest rates, growth, and risk. This is why scheduled data releases are often accompanied by heightened volatility and wider bid-ask spreads.
Case Studies in Real-World Context
Brexit and Sterling
In June 2016, the United Kingdom voted to leave the European Union. The result altered expectations for future trade arrangements, investment flows, productivity, and policy. Sterling depreciated rapidly as markets reassessed the expected path of the economy and the risk premium demanded by international investors. Subsequent negotiations, legal developments, and policy choices produced further moves as new information arrived.
Oil Prices and Commodity Currencies
Between mid-2014 and early 2016, global oil prices fell sharply. For oil exporters, the terms of trade deteriorated, fiscal revenues declined, and current accounts weakened. Currencies such as the Canadian dollar and Norwegian krone depreciated to absorb the shock, although the degree of movement differed with hedging practices, sovereign wealth buffers, and monetary responses. Large importers benefited, and their external positions improved.
Global Stress and the US Dollar
The US dollar plays a central role in global trade invoicing and financial intermediation. During periods of market stress, demand for dollar funding tends to increase. In 2008 and again in March 2020, the Federal Reserve established or expanded swap lines with foreign central banks to ease global dollar funding strains. The exchange value of the dollar strengthened as investors sought liquidity and safe assets, illustrating how institutional roles and risk sentiment can dominate cyclical data in the short run.
Exchange Rate Floors and Credibility
When authorities commit to an explicit exchange rate floor or band, credibility is crucial. If markets believe the commitment and the authority has sufficient resources, the currency may trade stably. If doubts grow, pressure can build. The discontinuation of a long-standing floor or peg can result in large, sudden moves because accumulated imbalances unwind at once.
Common Misconceptions
Several shortcuts can mislead analysis of exchange rates:
- Higher rates always strengthen a currency. If higher rates reflect rising inflation and falling real returns, the currency may not appreciate. The policy mix and credibility matter.
- Strong growth guarantees appreciation. Growth driven by unsustainable credit booms or widening deficits may weaken a currency if investors question durability.
- Intervention can always control the rate. Without credibility and adequate reserves, intervention may slow rather than prevent adjustment. Policy consistency is more powerful than sporadic transactions.
- Trade flows dominate all else. In modern financial markets, portfolio flows can exceed trade in driving near-term moves, particularly for freely traded currencies.
Putting the Elements Together
No single variable determines exchange rates. Instead, think in terms of a hierarchy of influences. Over days and weeks, prices respond to surprises relative to expectations, liquidity conditions, and order flow. Over quarters and years, relative inflation, productivity, and external balances set the broader direction. Policy frameworks and credibility shape how quickly the market transmits shocks into prices. Structural features such as demographics, the legal environment, and the depth of financial markets influence the risk premium embedded in a currency.
Analysts often use a combination of approaches. They track macro indicators to assess long-run valuation, monitor policy communications to infer expected rate paths, and pay attention to market positioning and liquidity to interpret short-run moves. While precise forecasts are difficult, the underlying logic is consistent. Currencies change because the world changes, and the exchange rate is the relative price that reconciles those changes across borders.
Key Takeaways
- Exchange rates are relative prices that adjust to balance currency supply and demand across trade, investment, and financial transactions.
- Short-run moves often reflect news surprises, expectations, and liquidity, while long-run trends relate more to inflation differentials, productivity, and external balances.
- Interest rate differentials matter, but their effect depends on real returns, policy credibility, and the economic context.
- Capital flows, terms of trade, and risk sentiment can move currencies quickly, sometimes overpowering trade fundamentals in the near term.
- Regime choice, institutional quality, and central bank actions shape how shocks translate into exchange rate changes, including the possibility of abrupt adjustments when pegs or floors shift.