Exchange rates are determined by supply and demand in foreign exchange markets, just like prices in any other market. Understanding what shifts these curves helps you predict whether a currency will strengthen or weaken. This topic covers the main forces behind those shifts, plus two important theories: arbitrage and purchasing power parity (PPP).

Forces Influencing Exchange Rates

Exchange rates reflect the interaction of supply and demand for a currency. To keep these straight, think about who is doing the buying and selling.

Supply of a currency comes from domestic residents who need to exchange their currency for foreign currency. When Americans buy Japanese cars or invest in European bonds, they supply dollars to the foreign exchange market (and demand foreign currencies in return).

Factors that increase the supply of a currency (pushing its value down):

Higher domestic inflation — domestic goods become relatively expensive, so residents buy more imports
Higher domestic interest rates — wait, this one is tricky. In most standard models, higher domestic interest rates actually attract foreign capital and decrease the supply of the domestic currency abroad. However, if higher rates reflect rising inflation expectations, the effect can reverse. For an intro course, focus on the next point instead.
Strong domestic economic growth — higher incomes lead to more spending on imports
Foreign economic downturns — fewer profitable investment opportunities abroad can shift capital flows, but the primary channel here is reduced foreign demand for exports

Demand for a currency comes from foreigners who want to buy domestic goods, services, or financial assets. When Japanese investors buy U.S. Treasury bonds, they demand dollars.

Factors that increase demand for a currency (pushing its value up):

Low domestic inflation — domestic goods stay competitively priced, attracting foreign buyers
Higher domestic interest rates — foreign investors seek higher returns, so they buy the domestic currency to invest
Foreign economic growth — wealthier foreign consumers buy more of your exports
Political and economic stability — investors prefer safe, predictable environments

The equilibrium exchange rate is reached when the quantity of a currency supplied equals the quantity demanded.

Appreciation: the currency's value rises due to market forces (e.g., the U.S. dollar strengthening against the euro, meaning each dollar buys more euros)
Depreciation: the currency's value falls due to market forces (e.g., the Japanese yen weakening against the U.S. dollar, meaning each yen buys fewer dollars)

A country's balance of payments also influences exchange rates. A persistent current account deficit, for instance, means the country is supplying more of its currency to buy foreign goods than foreigners are demanding it, which puts downward pressure on the currency.

Forces influencing exchange rates, Putting It Together: Supply and Demand | Macroeconomics with Prof. Dolar

Role of Arbitrage in Currency Trading

Arbitrage is the simultaneous buying and selling of the same asset in different markets to profit from a price difference. In currency markets, it works like this:

An arbitrageur notices that euros are cheaper in London than in New York (the exchange rate differs between the two markets).
They buy euros in London (where they're cheap) and simultaneously sell euros in New York (where they're expensive).
This increases demand for euros in London (pushing the London price up) and increases supply of euros in New York (pushing the New York price down).
The two prices converge, eliminating the profit opportunity.

Because currency markets are highly efficient and electronically connected, profitable arbitrage opportunities are rare and disappear within seconds. But the constant threat of arbitrage is what keeps exchange rates consistent across global markets.

Interest rate parity is a related concept. It states that the difference in interest rates between two countries should be offset by the expected change in the exchange rate. If it weren't, investors could earn risk-free profits by borrowing in the low-interest-rate country and investing in the high-interest-rate country. Arbitrage activity pushes markets back toward interest rate parity.

Forces influencing exchange rates, Demand and Supply Shifts in Foreign Exchange Markets | OpenStax Macroeconomics 2e

Purchasing Power Parity Effects

Purchasing Power Parity (PPP) is a theory stating that exchange rates should adjust so that identical goods cost the same in different countries when converted to a common currency. If a basket of goods costs $100 in the U.S. and €80 in Europe, PPP predicts the exchange rate should be 1.25 dollars per euro.

PPP comes in two versions:

Absolute PPP says the exchange rate should equal the ratio of price levels between two countries:

$S = \frac{P_1}{P_2}$

where $S$ is the exchange rate, $P_1$ is the price level in country 1, and $P_2$ is the price level in country 2.

Relative PPP is more practical. It says the percentage change in the exchange rate should roughly equal the difference in inflation rates:

$\%\Delta S = \%\Delta P_1 - \%\Delta P_2$

So if U.S. inflation is 5% and European inflation is 2%, relative PPP predicts the dollar should depreciate by about 3% against the euro.

PPP is useful for comparing living standards across countries and judging whether currencies are fairly valued:

An overvalued currency has a market exchange rate higher than what PPP would predict. The Swiss franc is a classic example, partly because Switzerland's high quality of life and safe-haven status keep demand elevated.
An undervalued currency has a market exchange rate lower than the PPP rate. The Chinese yuan has historically been cited as undervalued, which makes Chinese exports cheaper on world markets.

In practice, PPP holds better over long time horizons. In the short run, exchange rates deviate from PPP significantly because of capital flows, speculation, and trade barriers.

Exchange Rate Systems and Capital Flows

Not all currencies float freely. The system a country uses to manage its exchange rate matters for how supply and demand shifts play out.

Floating exchange rate: the currency's value is determined entirely by market supply and demand. The U.S. dollar, euro, and Japanese yen all float. Shifts in supply and demand translate directly into appreciation or depreciation.
Fixed exchange rate: the government pegs its currency's value to another currency or a basket of currencies. Saudi Arabia, for example, pegs the riyal to the U.S. dollar. The central bank must actively intervene to maintain the peg.
Currency intervention: even countries with floating rates sometimes intervene. A central bank can buy its own currency (using foreign reserves) to prop up its value, or sell its own currency to prevent excessive appreciation.

Capital flows are a major driver of exchange rate movements, especially in the short run. When foreign investors pour money into a country to buy stocks, bonds, or real estate, they demand that country's currency, pushing it up. When capital flows out, the currency weakens. These flows respond to:

Interest rate differentials between countries
Relative economic growth and investment opportunities
Political stability and investor confidence
Expectations about future exchange rate movements (speculation)

Large, sudden capital outflows can trigger sharp currency depreciations, which is why emerging market economies are particularly vulnerable to capital flight during global financial stress.

2,589 studying →