Put simply, exchange rates compare the value of one currency to another. They measure how much of one currency it takes to purchase a unit of another.
Exchange rates are ultimately determined in global foreign exchange markets by the supply and demand of currencies. Economic factors like inflation, interest rates, and geopolitical events influence these market forces.
This article explains the key factors that influence exchange rates. These include floating rates, fixed rates, macroeconomic factors, commodities, and the foreign exchange market itself (also known as FX or the forex market).
How are exchange rates determined?
Why do valuations of popular currencies fluctuate so much? Understanding how exchange rates are determined and what drives their volatility can help you get the most out of your money when traveling abroad or sending money across borders.
Under the current global floating exchange range system (more on that soon), currency fluctuations result from the forces of supply and demand on a global scale.
In short: Exchange rates compare the value of two currencies as they change over time. Currency values fluctuate constantly because they’re traded 24/7, five days a week.
Setting floating vs. fixed exchange rates
Currency exchange rates are determined in two main ways:
- Government policy, called fixed exchange rates
- Market forces, known as floating exchange rates
In a fixed exchange rate system, the government or central bank proactively maintains currency values relative to a specific standard. Historically, fixed exchange rates were anchored to gold or silver, with currency units defined as a specific weight of metal.
A drawback of fixed rates is that governments and central banks often have to work against market forces to maintain a currency peg (the policy a country uses to set a fixed exchange rate). This might call for intervention via monetary policy tools such as reserve management, interest rate adjustments, and capital controls.
Nowadays, most of the world operates with floating exchange rates, where governments and central banks allow currency values to fluctuate freely in financial markets.
Some argue that today’s global economy incorporates elements of both free-floating and managed systems, with occasional government intervention to maintain currency values.
Factors that determine exchange rates
Understanding how and why currency fluctuates can be a big help when sending money internationally or converting currency before you travel.
Of course, not everyone wants or needs an in-depth analysis. If that’s you, check out Western Union’s currency converter calculator. Use it to quickly calculate current exchange rates for popular currencies.
If you do want a deeper understanding of currency exchange rates, here are five factors that influence them:
Fixed exchange rates
Under fixed exchange rate systems, central banks actively shape monetary policy to peg their currency’s value within a narrow range.
This is intended to support their economic goals and maintain financial market confidence. Central banks have several monetary policy tools to do this. Here are three of the most important.
- Reserve management: Central banks maintain reserves of foreign currencies and can buy or sell them in the open market to influence demand and supply and stabilize exchange rates.
- Quantitative easing: Central banks buy government bonds and other securities to lower interest rates and increase the domestic money supply.
- Interest rate adjustments: By adjusting interest rates, central banks can attract or discourage the incoming flow of capital from outside the country, which impacts currency exchange rates.
Floating rates
Today, the world’s major currencies have floating exchange rates where currency values fluctuate in currency markets. This includes the world’s most traded currencies: the United States dollar, the euro, the Indian rupee, and the Japanese yen.
In this system, the supply and demand of the currencies themselves largely set currency values. In other words, market forces drive exchange rates. These forces include:
- Economic performance indicators, such as national gross domestic product (GDP) growth and industrial output, impact currency valuations.
- Political stability and governance build investor trust. Perceived political risk also influences currency values.
- Prevailing interest rates also play a crucial role. For example, higher rates can attract foreign capital, leading to appreciation of the currency.
- Trade and current account balances shift the supply and demand dynamics of currencies, as international demand for a nation’s exports will create demand for their currency.
Other important influences on currency exchange rates include inflation rates, market sentiment, geopolitical events, fiscal policies, commodity prices, and cross-border capital flows.
The interbank foreign exchange market also plays a huge role in determining global currency valuations. The interbank market is where major banks and financial institutions balance currency demand and supply to set benchmark exchange rates. These benchmark rates then guide retail exchange rates for consumers and businesses around the world.
Macro factors
Macroeconomic fundamentals such as inflation, interest rates, and economic growth can have huge effects on currency exchange rates. Here’s how:
- Inflation: High inflation reduces a currency’s purchasing power, making exports more expensive, weakening demand, and leading to a drop in a currency’s value.
- Interest rates: Central banks use interest rates to stimulate or cool economic activity, which affects exchange rates. Higher national interest rates attract foreign capital and make a currency more attractive to hold. Conversely, lower rates tend to have the opposite effect.
- Economic growth: GDP measures the health of an economy, and GDP growth signals stability and investment opportunities. This is attractive to foreign investors and can increase demand for the nation’s currency, positively affecting its valuation.
Commodities
Commodities are products of agriculture or mining, such as oil, steel, wheat, or rare earth minerals. They also have a major role in determining currency exchange rates, as changes in commodity prices can significantly impact a country’s export earnings.
How it works: When demand rises for a country’s main exports, it often strengthens demand for its currency. This brings increased revenue from exports, leading to a trade surplus.
This cycle improves the country’s terms of trade, which is the ratio of export prices to import prices. As terms of trade improve, the country earns more from exports than it spends on imports. This boosts a nation’s economic health and, consequently, the value of its currency.
Forex
When you send money internationally via money transfer services like Western Union, you participate in the world’s largest, most liquid financial market.
Foreign exchange (forex) markets are active around the clock across time zones. Other participants include banks, investment funds, corporations, and retail traders.
The Bank for International Settlements (BIS) reported a record $7.5 trillion per day traded in forex in 2022, up from $6.6 trillion three years earlier.
Here are three key drivers, among many, that cause exchange rate changes in the forex markets:
- Trader and investor positions: Speculation on currency values is a major driver of rate changes. Traders aim to profit from anticipated rate movements, and large speculative bets by institutions can become self-fulfilling as they drive significant market swings.
- Trading volumes: Dramatic changes in trading volumes of specific currencies suggest changing investor sentiment, affecting volatility and market depth.
- Market sentiment: Investor sentiment affects currency values. For example, during periods of economic uncertainty, the value of safe-haven currencies like the US dollar and Japanese yen tend to rise as investors seek stability.
FAQs
What factors determine exchange rates?
The key factor in determining currency exchange rates is the supply and demand of currencies on global foreign exchange markets. In short, a currency’s price will rise if demand is high, and its price will fall if demand is low.
Beyond that, the dynamics of supply and demand are influenced by many political and economic forces. These forces include inflation rates, interest rates, economic growth, political stability, and geopolitical events.
How does the government determine the exchange rate?
Nowadays, the world’s major currencies have floating exchange rates. In this system, market forces determine currency values, limiting a government’s ability to determine exchange rates.
Governments occasionally intervene to meet economic objectives. To do this, governments and central banks use monetary policy tools such as interest rate adjustments, buying or selling currency in the open market, and capital controls.
How do banks decide exchange rates?
Commercial banks play a major role in determining global exchange rates. They do this on the global interbank forex market, where currency supply and demand set benchmark exchange rates.
Banks engage in a range of activities that help determine currency exchange rates. These activities include actively trading currencies, fulfilling orders, managing risk for clients, and more.
