What Determines Exchange Rates? Key Factors That Move Currencies

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Exchange rates are set by supply and demand for currencies, driven by a handful of economic forces: relative inflation, interest rate differentials, the current account balance, public debt and credit risk, the terms of trade, and political and economic stability. Expectations about all of these, plus central bank policy, decide how much of one currency people want to hold compared with another. No single factor dominates at all times, and economists disagree on their relative importance. The U.S. dollar follows the same rules, with extra demand from its role in global trade, finance and central bank reserves.

How exchange rates are set

A currency’s price moves for the same reason any price moves. When foreigners want more of a country’s goods, services, bonds or shares, they must buy its currency to pay for them, which pushes its value up. When residents want more foreign goods and assets, they sell their own currency to get foreign money, which pushes its value down.

Because every rate compares two currencies, EUR/USD can rise because the euro is gaining or because the dollar is weakening. Most currencies are measured against a few benchmarks: the U.S. dollar, the euro, the British pound, the Japanese yen and the Chinese yuan.

Who decides currency value

Under a floating regime, used by the United States, the eurozone, Japan, the UK and many others, the market sets the rate as banks, funds, corporations, governments and traders buy and sell currency, with large dealing banks and central banks most influential on major pairs.

Under a fixed or pegged regime, a central bank commits to a target rate and defends it by buying or selling its own currency from its foreign exchange reserves. Many countries sit in between with a managed float. The International Monetary Fund does not set exchange rates.

The main factors that move currencies

1. Differences in inflation

Inflation erodes what a currency can buy. A country whose inflation runs below its trading partners’ tends to see its currency appreciate against theirs, as low-inflation Japan, Germany and Switzerland did in the second half of the 20th century.

The idea behind this is purchasing power parity: over long periods, exchange rates tend to adjust so that a basket of goods costs roughly the same across countries. It is a long-run tendency, not a short-term forecast tool.

Money supply growth feeds directly into this: if a central bank expands the money supply faster than its trading partners, prices rise and the currency tends to lose value. In hyperinflation, as in Weimar Germany in 1923 or Zimbabwe in the late 2000s, residents rush to swap money for foreign currency or real goods.

2. Interest rate differentials

Higher interest rates give investors a better return than they can earn elsewhere, which attracts foreign capital. To buy those higher-yielding deposits and bonds, investors must buy the currency, so the exchange rate tends to rise. Lower rates tend to have the opposite effect.

The effect weakens if the high-rate country’s inflation is much higher, because investors care about the real return: a 10% deposit rate with 12% inflation is a negative real return. Markets also react to expected rate changes, so a currency can move when a central bank signals future policy. The carry trade, borrowing in a low-rate currency to hold a higher-rate one, is a direct expression of this differential.

3. Current account balance

The current account records a country’s payments with the rest of the world for goods, services, interest and dividends. A deficit means the country spends more abroad than it earns and must finance the gap by borrowing from foreigners or selling them assets.

A deficit country supplies more of its own currency than foreigners want for its products. That excess supply tends to push the exchange rate down until domestic goods become cheap enough abroad, and foreign goods expensive enough at home, to narrow the gap. A deficit can persist for years if foreign investors are willing to fund it, which is why investment flows matter as much as trade.

4. Public debt and credit risk

Government deficits can stimulate the domestic economy, but large debts can make a country less attractive to foreign investors:

• Inflation risk. Heavy debt creates an incentive to let inflation run, or in the worst case to print money, so debt is repaid in money worth less.
• Supply of securities. A government that cannot fund itself domestically must sell more bonds to foreigners, lowering their prices and raising yields.
• Default risk. If investors fear a country cannot meet its obligations, they become less willing to hold assets in its currency.

For this reason, a country’s sovereign credit rating is an important input. A downgrade can trigger capital outflows and currency weakness.

5. Terms of trade

The terms of trade compare a country’s export prices with its import prices. If export prices rise faster than import prices, the terms of trade improve: the country earns more per unit it sells abroad, export revenue rises, and demand for its currency rises with it. If export prices lag import prices, the currency tends to weaken.

This is why currencies of commodity exporters such as Australia, Canada or Norway often move with prices of metals, oil and gas. A commodity price boom improves their terms of trade; a slump worsens them.

6. Political and economic stability

Investors and companies favor stable countries with sound economies and predictable institutions. Elections with uncertain outcomes, conflict, sudden policy shifts or weak rule of law can cause a loss of confidence and a move of capital toward safer places. In periods of global stress, money often flows toward perceived safe havens, historically the U.S. dollar, the Swiss franc and the Japanese yen, even when the stress originates in those countries.

7. Expectations, speculation and central bank intervention

Currency markets trade continuously, so prices often move on what traders expect rather than on current data. An inflation report or central bank meeting moves a pair mainly when the result differs from expectations, which is why rates can seem to rise and fall at random over short periods.

Central banks can also act directly. A bank defending its currency sells foreign reserves and buys its own money; one trying to weaken it does the reverse. Larger reserves give a central bank more capacity to smooth sharp moves.

What determines demand for the U.S. dollar

The dollar responds to all of the factors above, but it also carries demand that most currencies lack:

• Reserve currency status. Central banks hold a large share of their reserves in dollars, largely in U.S. Treasury securities.
• Trade invoicing. Much international trade, including oil and other commodities, is priced and settled in dollars, so companies worldwide need them.
• Deep, open capital markets. The size and liquidity of U.S. bond and stock markets, with free movement of capital, make dollar assets easy to trade in large amounts.
• Dollar-denominated debt. Governments and companies outside the U.S. that borrow in dollars must buy dollars to repay.
• Safe-haven flows. In crises, demand for dollar assets often rises.

Nominal, real and effective exchange rates

The quoted rate is the nominal exchange rate. The real exchange rate adjusts it for price levels:

Real exchange rate = nominal rate × (foreign price index ÷ domestic price index), with the nominal rate quoted as domestic currency per unit of foreign currency.

Hypothetical example: the nominal rate is 1.00 domestic unit per foreign unit. Over a year, domestic prices rise 10% and foreign prices rise 2%, but the nominal rate stays at 1.00. The real rate becomes 1.00 × (1.02 ÷ 1.10) ≈ 0.93. Domestic goods have become relatively more expensive for foreigners, even though the quoted rate did not move. This is the pressure that, over time, tends to push the high-inflation currency down.

An effective exchange rate measures a currency against a weighted basket of its trading partners’ currencies, showing whether it is strengthening broadly or only against one partner.

How exchange rates affect people and businesses

Consumers: a weaker currency makes imports more expensive, which matters most in countries that import many cars, electronics or fuel. A stronger currency makes imports cheaper.

Businesses: exporters earn more in home currency when their currency weakens, as long as foreign prices hold. Importers and companies with foreign-currency debt face higher costs. Profits of firms with foreign suppliers, customers or loans swing with exchange rates unless hedged.

Investors: returns on foreign assets depend on both the asset and the currency. A foreign stock that gains 8% in local terms while that currency falls 8% against yours leaves you roughly flat.

Is a strong currency good or bad?

It depends on who you are. A strong U.S. dollar lets American travelers get more euros or pounds and makes imports cheaper. It also makes U.S. tourism more expensive for visitors and U.S. goods pricier abroad, which can either raise exporters’ margins or push foreign buyers toward local alternatives. A weak currency helps exporters and tourism but raises import prices and can feed inflation.

A country cannot simply decide to raise its currency’s value in a lasting way. Intervention and pegs can hold a rate for a time, but sustained strength comes from the underlying factors above.

The Bottom Line

Exchange rates matter to travelers, importers, exporters and anyone holding foreign assets, since currency moves can raise costs or erase investment gains. Short-term swings often follow surprises against market expectations, so they are hard to predict. Over longer periods, inflation, interest rates, trade balances, debt and stability shape a currency's value, and pegs or intervention can only hold a rate for a time.