Why Do Exchange Rates Change Every Day?

Central banks set short-term interest rates, and higher rates attract foreign capital seeking better returns on bonds and deposits. When the US Federal Reserve raises rates, investors worldwide sell other currencies and buy dollars to invest in US assets. This increased demand pushes the dollar's value up.

The key is not just current rates but rate expectations. If markets expect the Fed to raise rates next month, the dollar often strengthens today as traders position in advance. This is why currency markets react so sharply to economic data releases — not because the data itself moves rates, but because it changes rate expectations.

High inflation erodes a currency's purchasing power. If a country has 10% inflation and its trading partners have 2%, its goods become more expensive relative to theirs. Demand for its currency falls (because its exports become less competitive), which weakens the exchange rate. This relationship is formalized in purchasing power parity (PPP) theory.

In practice, inflation affects exchange rates both directly (through eroded purchasing power) and indirectly (by influencing central bank rate decisions — high inflation usually triggers rate hikes, which can strengthen the currency short-term even as it signals long-term problems).

Countries that export more than they import run trade surpluses, generating demand for their currency (foreign buyers must purchase the exporting country's currency to pay for goods). Countries with trade deficits see more of their own currency sold to pay for imports. Japan's historically strong yen was partly sustained by its persistent trade surpluses.

Capital flows — foreign direct investment and portfolio investment — can dwarf trade flows. A country that attracts significant foreign investment sees sustained demand for its currency, supporting a stronger exchange rate.