Exchange rates are determined primarily by supply and demand in the foreign exchange market, where roughly $7.5 trillion changes hands every day.1Bank for International Settlements. OTC Foreign Exchange Turnover in April 2022 What moves that supply and demand is a mix of interest rates, inflation, economic growth, trade flows, central bank action, political stability, and market psychology. Some of these forces grind on a currency over months and years. Others can move it five percent in an afternoon on a single headline. How much any of them matters for a given currency depends first on the exchange rate system its government uses.
The Exchange Rate System Comes First
Before any economic factor gets to work, the country’s chosen system decides how much freedom the market actually has to set the price.
Free-Floating Currencies
Under a free float, supply and demand alone set the price. The United States, the eurozone, Japan, and most large economies operate this way.2Federal Reserve Bank of Minneapolis. Exchange Regimes: One Hand, the Other Hand, Both Hands No one guarantees a level, so the rate can swing hard when sentiment shifts. The tradeoff is that the currency adjusts naturally to conditions rather than forcing the government to defend a specific number.
Fixed or Pegged Currencies
A fixed system locks the currency’s value to another currency or to a basket weighted by trade and capital flows.3International Monetary Fund. Classification of Exchange Rate Arrangements and Monetary Policy Frameworks The central bank has to stand ready with enough foreign reserves to buy or sell its own currency whenever the market pulls away from the target. The payoff is predictability. The cost is that domestic monetary policy has to serve the peg first, leaving less room to respond to local conditions.
Managed Floats
Most of the world sits between the two extremes. The currency trades on the open market, but the central bank steps in to smooth sharp moves or nudge the rate in a preferred direction.4NBER. Systematic Managed Floating China’s management of the renminbi and India’s periodic action on the rupee are common examples. Part of the market pressure gets absorbed by reserve purchases and sales, and part shows up as a real rate change.
Interest Rates and Capital Flows
Interest rates are the single most-watched driver of short-term currency moves. When a central bank raises its benchmark rate, assets denominated in that currency start offering higher yields, and foreign investors have to buy the currency to access them.5Board of Governors of the Federal Reserve System. Monetary Policy and Exchange Rates During the Global Tightening That surge in demand pushes the exchange rate up. Rate cuts do the opposite.
This dynamic feeds an entire trading strategy called the carry trade: investors borrow in a low-interest-rate currency, convert into a high-interest-rate currency, and pocket the difference. Piled up across billions, those trades amplify the rate-differential effect. High-yielding currencies get bid higher, low-yielders get sold.
Inflation and Real Purchasing Power
Inflation works as a slow drag. As domestic prices rise, each unit of currency buys less, and investors start looking for alternatives. A country with persistently high inflation tends to see its currency weaken against countries where prices are more stable, because the real return on holding it erodes.6U.S. Bureau of Labor Statistics. How Currency Appreciation Can Impact Prices: The Rise of the U.S. Dollar
Interest rates and inflation create a constant tug-of-war. A central bank might raise rates to attract capital, but if inflation is rising just as fast, the real yield (the rate minus inflation) has not actually improved. That is why traders watch real rates rather than nominal ones when they judge which way a currency is headed.
Economists also use purchasing power parity (PPP) as a rough benchmark. The idea: if a basket of goods costs $100 in the United States and ¥640 in Japan, PPP suggests the rate should be about 6.4 yen per dollar.7Bank of Canada. Purchasing-Power Parity: Definition, Measurement, and Interpretation Real market rates deviate from PPP constantly because productivity gaps, capital flows, and trade barriers all interfere. A currency trading below its PPP rate does not always mean it is undervalued. Often it just means goods and services are cheaper there. Still, extreme deviations tend to correct eventually.
Economic Growth and Government Debt
Strong output pulls in foreign investment. When GDP growth is solid and unemployment is low, investors expect better corporate profits and higher returns, which drives demand for the local currency. Weak growth pushes capital elsewhere and softens the currency.
Debt levels matter too, but the relationship is less mechanical than most people assume. High debt-to-GDP ratios can erode confidence in a country’s long-term fiscal position, raising fears of eventual inflation or default, and when confidence slips, borrowing costs rise and the currency tends to weaken.8International Monetary Fund. Global Debt Remains Above 235% of World GDP Yet Japan and the United States have carried enormous debt loads for decades without their currencies collapsing, because investors still trust the institutions and the ability to service the debt. Context outweighs the raw number.
Trade Balances
The difference between exports and imports creates a structural current of supply and demand. When a country runs a trade surplus, foreign buyers need its currency to pay for goods, which supports the exchange rate. A persistent deficit works the other way: domestic buyers sell their own currency to purchase foreign goods, adding supply to global markets and putting downward pressure on the rate.
The effect is slower-moving than the interest rate channel, and it comes with a wrinkle. When a currency depreciates, you might expect the trade deficit to shrink right away since exports just got cheaper for foreign buyers. In practice the deficit often widens first, because existing import contracts are still priced at the old rate and export volumes take time to respond. Economists call this the J-curve effect. The adjustment usually runs one to two years before the improvement shows up in the numbers.
The United States is an unusual case. Despite a trade deficit exceeding $900 billion in 2024, the dollar stays strong partly because so many global transactions are priced in dollars regardless of whether the U.S. is involved.9Federal Reserve Bank of St. Louis. The U.S. Dollar’s Role as a Reserve Currency That structural demand offsets pressure a deficit of that size would normally create.
Central Bank Intervention
Central banks do more than set interest rates. They have a full toolkit for managing currency values and they use it often, especially under managed floats.
The most direct tool is buying or selling foreign exchange reserves. If a currency is falling too fast, the central bank can sell reserves of foreign currencies and buy its own, reducing the supply on the market and supporting the price. If the currency is rising uncomfortably, the bank does the reverse.10Bank for International Settlements. Foreign Exchange Intervention and Financial Stability The market often tests whether a bank has enough reserves to keep intervening.
Broader monetary policy also feeds through. Quantitative easing, where the central bank creates reserves to purchase government bonds and other assets, pushes down long-term interest rates and tends to weaken the currency by making it less attractive to yield-seeking investors.11Bank of England. Quantitative Easing Tightening does the opposite: higher rates and reduced liquidity attract capital and strengthen the currency.12Federal Reserve. The Fed Explained – Monetary Policy The challenge is calibrating these tools so the currency effect does not undermine the domestic goals the policy was set up to achieve.
Political Stability and Safe-Haven Flows
Political conditions can override economic data entirely. During wars, financial crises, or severe political uncertainty, investors move toward currencies they consider safe stores of value. The U.S. dollar, the Swiss franc, and in certain crises the Japanese yen have historically played that role.
The effect often looks counterintuitive. The United States might be running large deficits and facing domestic turmoil, and its currency still strengthens during a global crisis because investors are fleeing something worse. Meanwhile, a country with solid fundamentals but an unstable government can see its currency plunge overnight on news of a coup attempt or contested election. Market psychology outweighs the spreadsheets during these episodes, and the flight to safety can be self-reinforcing as falling currencies trigger more selling.
Speculation and Market Sentiment
Most of the $7.5 trillion that changes hands daily in foreign exchange has nothing to do with buying imported cars or paying for overseas equipment.1Bank for International Settlements. OTC Foreign Exchange Turnover in April 2022 The bulk is financial: banks hedging exposures, funds betting on rate moves, and algorithms trading on millisecond price gaps. Exchange rates therefore respond as much to expectations about the future as to today’s fundamentals.
If enough traders believe a country’s economy is weakening, they sell the currency in anticipation of a decline, and that selling produces the decline they predicted. These self-fulfilling moves can push rates away from what any economic model considers fair value, sometimes for extended stretches. That is why central bank communication is drafted so carefully. A single sentence from a Federal Reserve chair hinting at future rate cuts can move the dollar more in 30 minutes than a month of trade data.
Why the Dollar Distorts Every Other Rate
Any answer to how exchange rates are set has to account for the dollar’s unusual position. As of the third quarter of 2025, U.S. dollar-denominated assets made up roughly 57% of global foreign exchange reserves.9Federal Reserve Bank of St. Louis. The U.S. Dollar’s Role as a Reserve Currency Oil, most commodities, and much of international trade are priced in dollars. Countries around the world hold dollars because they need them to participate in global commerce, not because they endorse U.S. fiscal policy.
That structural demand puts a floor under the dollar’s value that other currencies simply do not have. It also means changes in the dollar ripple outward. When the Federal Reserve raises rates and the dollar strengthens, emerging markets that borrowed in dollars suddenly face bigger debt payments in local currency terms, which can trigger capital outflows and further depreciation. That feedback loop has sparked financial crises in Latin America, Southeast Asia, and elsewhere. The system is not a collection of independent currency pairs. It is a network, and the dollar sits at the center of it.