How Currency Exchange Rates Are Determined by Global Markets

$7.5 Trillion Changes Hands in Forex Markets Every Single Day

The Bank for International Settlements' 2022 Triennial Survey found that global foreign exchange (forex) market turnover averaged approximately $7.5 trillion per day—making it the largest and most liquid financial market in the world. By comparison, the New York Stock Exchange handles roughly $20 billion daily in equity trading. The sheer scale of currency trading means exchange rates respond almost instantaneously to economic news, policy announcements, and geopolitical events.

Exchange rates determine how much one currency is worth in terms of another. For businesses conducting cross-border trade, travelers, and international investors, exchange rate movements can represent significant costs or windfalls. Understanding what drives them requires examining several interconnected mechanisms.

Exchange Rate Systems: Floating vs. Fixed

Countries choose how to manage their currencies, and the system chosen fundamentally shapes how rates are determined.

Most major world currencies operate under managed or freely floating systems. The shift to floating rates for major economies occurred after the Bretton Woods system collapsed in 1971, when President Nixon suspended the dollar's convertibility to gold.

What Moves Exchange Rates

Interest Rate Differentials

Interest rate differentials between countries are among the most powerful short-term drivers of exchange rates. When U.S. interest rates rise relative to European rates, dollar-denominated assets (Treasury bonds, money market funds) become more attractive to global investors. They buy dollars to invest, increasing dollar demand and pushing the dollar's value higher relative to the euro.

This relationship underpins the "carry trade"—borrowing in low-interest-rate currencies (historically the Japanese yen) and investing in higher-yielding currencies. In 2023, as the Fed raised rates aggressively while Japan kept rates near zero, the yen weakened to roughly 150 JPY per USD, a 30-year low.

Inflation and Purchasing Power Parity

Purchasing Power Parity (PPP) is the theoretical exchange rate at which prices for identical goods would be equal across countries. If a basket of goods costs $100 in the U.S. and £80 in the U.K., PPP implies the exchange rate should be approximately $1.25 per pound.

In practice, exchange rates deviate significantly from PPP. The Economist's Big Mac Index—published since 1986—uses the price of McDonald's Big Mac in local currencies as a simplified PPP test. In 2024, it suggested the Swiss franc was overvalued against the dollar by approximately 30%, while the Chinese yuan was undervalued by about 36%.

Trade Flows and Current Account Balances

Countries that export more than they import generate demand for their currency, as foreign buyers must obtain local currency to purchase exports. Persistent trade surpluses—like those run by Germany and Japan—tend to support currency strength over long periods. Persistent deficits create supply of the currency as domestic importers convert it to foreign currencies.

Speculation and Sentiment

Speculative capital flows dwarf trade-related flows. Forex traders take positions based on anticipated movements in rates, economic data, and geopolitical developments. Large hedge funds, bank proprietary trading desks, and sovereign wealth funds all participate. A trader who expects the British pound to fall will short it, increasing pound supply and potentially contributing to the decline they anticipated—a self-fulfilling element common in currency markets.

Central Bank Intervention

Central banks occasionally intervene directly in forex markets to smooth disorderly movements or defend target levels. Japan intervened multiple times in 2022–2023 to support the yen when it fell sharply against the dollar. China's People's Bank of China manages the yuan (renminbi) within a daily trading band around a central rate it sets each morning.

Interventions involve buying or selling the domestic currency in exchange for foreign reserves. A central bank defending a weakening currency sells foreign reserves and buys domestic currency. Reserve depletion limits how long this can continue—the 1997 Asian financial crisis involved speculative attacks on pegged currencies that exhausted reserves and forced devaluations in Thailand, Indonesia, South Korea, and others.

Real vs. Nominal Exchange Rates

• Nominal exchange rate: The actual observed rate at which currencies trade in markets (e.g., 1.10 USD per EUR)
• Real exchange rate: The nominal rate adjusted for relative inflation between two countries; measures actual competitiveness of goods and services

A country with higher inflation than its trading partners sees its real exchange rate appreciate even if the nominal rate stays flat, making its exports less competitive. Real exchange rate movements determine trade flows over the medium and long term more reliably than nominal rates alone.

Impact on Businesses and Consumers

Exchange rate movements are simultaneously prices, policy tools, and barometers of relative economic conditions—which is why the forex market's enormous daily volume reflects so many different participants managing so many different exposures.