How Exchange Rates Work
Understanding Why Currency Prices Change
Introduction
An exchange rate is the value of one currency compared to another.
It determines how much of one currency you receive when exchanging it for another.
Exchange rates constantly change due to global economic activity, supply and demand, and financial market forces.
What Determines an Exchange Rate?
Exchange rates are primarily driven by:
- Supply and demand
- Economic performance
- Interest rates
- Inflation levels
- Political stability
- Global trade flows
When demand for a currency increases, its value tends to rise.
When demand falls, its value tends to decline.
Supply and Demand in Forex
If more investors want to buy US Dollars:
- Demand increases
- USD strengthens
If investors start selling US Dollars:
- Supply increases
- USD weakens
Currency prices move based on this balance.
Role of Interest Rates
Interest rates strongly influence currency values.
Higher interest rates often:
- Attract foreign investment
- Increase currency demand
- Strengthen the currency
Lower interest rates may reduce demand and weaken the currency.
Central banks play a major role here.
Impact of Inflation
Countries with lower inflation generally have stronger currencies over time.
High inflation:
- Reduces purchasing power
- Weakens currency value
Stable economies tend to maintain stronger currencies.
Economic Indicators That Move Exchange Rates
Forex markets react to:
- Employment data
- GDP growth reports
- Central bank announcements
- Trade balances
- Political events
Major news releases can cause rapid currency movement.
Fixed vs Floating Exchange Rates
Some countries use:
🔹 Floating Exchange Rates
Value determined by market forces (most major currencies).
🔹 Fixed Exchange Rates
Currency value pegged to another currency.
Most global Forex trading involves floating systems.
Why Exchange Rates Fluctuate Daily
Currencies trade continuously across global markets.
As economic data is released and investors react, exchange rates adjust instantly.
Forex is highly sensitive to global events.
Final Thoughts
Exchange rates reflect the strength and stability of national economies.
Understanding what moves currency prices builds a strong foundation before learning leverage, margin, and trading strategies.