How Are Exchange Rates Decided?
Understanding Currency Value and Its Impact on Global Finances
Exchange rates play a vital role in the global economy, influencing international trade, investments, and even travel costs. If you've ever wondered why the value of a currency changes, understanding the factors behind exchange rate movements can help you make sense of this important financial topic.
This guide explains how exchange rates are determined, what affects them, and why they matter for individuals, businesses, and investors.
What Is an Exchange Rate?
An exchange rate is the value of one currency compared to another. For example, if £1 = $1.25, this means that one British pound (GBP) is worth 1.25 US dollars (USD). Exchange rates change daily due to a variety of economic, political, and financial factors.
Key Factors That Influence Exchange Rates
Supply and Demand
At its core, exchange rates are based on supply and demand in the foreign exchange (Forex) market.
When demand for a currency increases, its value strengthens.
When demand decreases or supply rises, the currency weakens.
For example:
If a country exports more goods, international buyers need its currency to pay for those goods, increasing demand and strengthening the currency.
If a country imports more than it exports, it increases demand for foreign currencies, which can weaken its own currency.
Interest Rates and Monetary Policy
Central banks set interest rates, which influence exchange rates by affecting the attractiveness of a country’s currency to investors. Higher interest rates typically increase demand for a currency, strengthening its value, while lower interest rates can lead to depreciation as investors seek better returns elsewhere.
For example, if the Bank of England raises interest rates, investors may move money into GBP-denominated assets, increasing demand for the pound and raising its value.
Inflation and Purchasing Power
A country’s inflation rate affects its exchange rate:
Lower inflation helps a currency appreciate because the purchasing power of that currency remains strong compared to others.
Higher inflation weakens a currency because goods become more expensive, making it less attractive to foreign buyers.
Economic Stability and Performance
A country’s economic health affects its currency value. Key factors include:
GDP Growth – A strong economy attracts investment, supporting a stronger currency.
Employment Rates – Stable job markets signal economic strength, increasing investor confidence.
Political Stability – Uncertainty can weaken a currency as investors move money to safer economies.
For example, major political events like elections, policy changes, or international trade agreements can impact investor confidence, leading to fluctuations in currency values. Uncertainty around government stability, economic reforms, or geopolitical tensions can also influence exchange rates as investors seek safe-haven currencies.
Balance of Trade and Current Account
A country’s trade balance—the difference between exports and imports—influences its currency value.
Trade Surplus: If exports exceed imports, demand for the country’s currency increases, strengthening its value.
Trade Deficit: If imports exceed exports, demand for foreign currencies rises, which can weaken the home currency.
Market Speculation and Investor Sentiment
Traders and investors in the Forex market influence exchange rates through buying and selling currencies based on speculation.
If investors believe a currency will increase in value, they buy more of it, driving up demand.
If sentiment turns negative, large sell-offs can weaken a currency.
For example, speculation about interest rate changes or economic downturns can lead to sudden currency fluctuations.
Fixed vs. Floating Exchange Rates
Currencies operate under two main exchange rate systems:
Floating Exchange Rates – Most major currencies (e.g., GBP, USD, EUR) fluctuate based on supply and demand.
Fixed Exchange Rates – Some countries peg their currency to another, such as the US dollar, to maintain stability. The central bank actively intervenes to keep the rate steady.
Why Do Exchange Rates Matter?
Exchange rates impact almost everyone, from individuals planning holidays to businesses trading internationally. The value of a currency can influence purchasing power, profit margins, and investment returns. Understanding how exchange rates affect different financial decisions can help people and businesses prepare for currency fluctuations and make more informed choices.
For Travellers
A strong home currency means you get more foreign currency when exchanging money, making travel abroad cheaper.
A weaker home currency means foreign travel becomes more expensive.
For Businesses (Importers & Exporters)
Exporters benefit when their home currency weakens, as their products become cheaper for foreign buyers.
Importers face higher costs when their home currency weakens, as foreign goods become more expensive.
For Investors
Currency fluctuations affect international investments.
A rising home currency can reduce the value of overseas investments.
A weaker home currency can increase foreign investment returns.
Final Thoughts
Exchange rates are influenced by many factors, including economic fundamentals, market demand, and investor expectations. While they may seem unpredictable, understanding these drivers can help individuals, businesses, and investors make better financial decisions.
Whether you're planning a holiday, investing in international markets, or running a business, keeping an eye on exchange rate trends can help you maximise opportunities and manage risks.