How do exchange rates work, and why do currencies move?
Short answer
An exchange rate is the price of one currency in terms of another. Floating rates move with supply and demand, which respond to interest rates, inflation, trade and capital flows, and market sentiment.
Reading a currency pair
A rate is quoted as a pair: base currency / quote currency. If EUR/USD is quoted at 1.10 (an illustrative number), one euro costs 1.10 US dollars. When the number rises, the base currency has strengthened against the quote currency.
The spot rate is for immediate exchange. A forward rate is agreed today for exchange on a later date. Banks and money changers add a spread or fee, so the rate you receive is worse than the mid-market rate.
Floating and fixed regimes
Most major currencies float: the market sets the rate. Some currencies are pegged to another currency or a basket, and the central bank holds reserves and adjusts policy to defend the peg. Others use a managed float with occasional intervention.
Why currencies move
Interest rate differences: higher returns on assets in one currency can attract capital and raise its value. Inflation differences: persistently higher inflation tends to erode a currency’s purchasing power over time. Trade and capital flows: demand for a country’s exports and investments creates demand for its currency. Risk sentiment: in uncertain times investors often favour currencies seen as safe. Policy and intervention: central banks can buy or sell currency, and policy surprises move markets.
These factors interact and no single one reliably predicts short-term moves.
Real exchange rates
Purchasing power parity (PPP) is the idea that, in the long run, exchange rates adjust so that a similar basket of goods costs the same in each country. In practice it is a rough benchmark, and economists also use real effective exchange rates that adjust for inflation across trading partners.
Amount in quote currency = amount in base currency x exchange rate