What causes currency exchange rates to rise and fall?

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Currency values are always relative.

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We all know what money is. It’s what we use to buy and sell goods and services and, from a savings and investing standpoint, it’s how we keep score of (i.e., place a value on) the assets we own.

But how much does money cost? That might sound like a strange question, because we typically associate price tags with goods and services, not money itself.

But money does have a price tag. It’s called an exchange rate, and in the global currency market, it’s always in relation to another currency.

Think of an exchange rate as a price tag for purchasing one currency with another. For example: What does a dollar cost? It depends on the country where you’re asking the question.

For someone from Germany or France, as of June 2023, the answer would be 91.7 euro cents. (Note: The global currency market deals in big numbers, where fractions of pennies make a real difference.)

We can flip that around and view it from the opposite perspective. So if an American wants to know how much a euro costs, as of June 2023, it’s one dollar and nine cents.

So there you have it: The price tag for buying dollars with euros or euros with dollars, aka the “exchange rate.” Notice that 0.917 is the inverse of 1.09 and vice versa. That’s not a coincidence; it’s how currency pairs work. It’s simply the ratio of one relative to the other, no matter which currency pair you’re looking at.

As of June 2023, a British pound costs $1.28. So how much does a dollar cost for a Londoner? About 78 pence. And if you’re vacationing in Niagara Falls—and crisscrossing both sides of the border—a U.S. dollar will cost C$1.321, while a Canadian dollar will cost 1/1.321 = $0.757, or 75.7 cents (USD).

And so on.

The value of a country’s currency depends on several factors, but ultimately, it all boils down to global supply and demand.

The greater the demand for a country’s currency, the higher its value or exchange rate tends to be in the global market. The opposite is also true. If demand for a currency falls, its value will decrease.

What factors affect supply and demand?

Other factors, including economic stability, political stability, public debt, and even speculation, can also influence the direction of exchange rates. These factors are dynamic, and they interact with one another in complex ways. But ultimately, a currency’s exchange rate boils down to supply and demand, plus expectations for future supply and demand.

One example of extreme currency volatility caused by widespread macroeconomic and geopolitical uncertainty was that of the British pound (GBP) falling 12% against the euro (EUR) starting on June 23, 2016, as a result of the referendum vote for the United Kingdom to leave the European Union (“Brexit”).

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Figure 1: EXIT THE UNION, ENTER VOLATILITY. Between June 24 and July 7, 2016, the British pound fell 12% versus the euro (GBP/EUR) after the United Kingdom voted to leave the European Union.

Source: StockCharts.com

Why such a dramatic plunge? The vote’s outcome took the market by surprise. With nearly 52% of all participants voting for Brexit, public opinion was virtually split down the middle, and the market outcome immediately proved unfavorable.

Investors were suddenly unsure about Britain’s economic future and how trade relations might play out following the exit. Some participants thought Brexit would negatively affect the UK’s economy, while others were simply unsure. As a result, many participants sold their British pound holdings, anticipating further declines.

The value of a currency is always in relation to another currency. So if a currency rises or falls against another, it can mean several things.

For example, let’s take the EUR/USD pair (euro against the US dollar). If the euro were to rise, there could be more than one way to interpret the move:

As you can see, a rise in the euro exchange rate compared to the dollar isn’t as straightforward as it might seem. This is because a country’s currency acts like a barometer of (or proxy for) its overall economic health in terms of global trade and investment. So when you trade currencies as an investment, it’s essentially a statement about your view on the overall economic conditions of the countries involved.

The cost of any currency is expressed in its exchange rate, which is like a currency’s price tag. The rise or fall of the exchange rate itself depends on several factors, including inflation, interest rates, trade balance, and overall economic and political stability. Currency pairs have different exchange rates because the global demand for each currency—meaning the demand for the country’s goods or financial assets—varies.

Not only that, but currency fluctuations can yield multiple interpretations. Yes, it’s complex, but only as complex as what a currency represents—the dynamics of a country’s economy.