What Moves Exchange Rates

In a floating system, an exchange rate is a price set by supply and demand for currencies. Demand for a currency rises when foreigners want a country's exports, its assets or its bonds; it falls when residents buy imports or invest abroad. In the long run, purchasing power parity suggests currencies drift toward rates that equalize the price of goods, so high-inflation countries tend to see their currencies weaken.

In the short run, interest rates and expectations dominate: higher interest rates attract investors, strengthening a currency, while political uncertainty or fears of default can trigger rapid sell-offs. Governments sometimes intervene, as in the 1985 Plaza Accord, when five major economies agreed to push down an overvalued dollar. Because expectations can feed on themselves, exchange rates often overshoot, moving further than fundamentals justify, which helps explain why forecasting them is notoriously difficult.