What Drives Currency Exchange Rates? Understanding the Forces Behind FX Markets

Currency exchange rates are driven by interest rate differentials, inflation rates, capital flows, and central bank policy decisions. Interest rate changes typically move currencies 3-5% within six months, while major policy shifts can drive 15-30% moves over 12-18 months. The Federal Reserve's 2022-2023 rate hikes pushed the dollar 18% higher in ten months, demonstrating how monetary policy directly impacts exchange rates through capital flows seeking higher yields.

Introduction

The foreign exchange market processes $7.5 trillion daily—25 times larger than all global stock markets combined—with currency values fluctuating every second based on economic forces that reshape global capital flows. According to the Bank for International Settlements' 2022 Triennial Survey, daily FX turnover increased 14% from $6.6 trillion in 2019, reflecting the market's role as the backbone of international commerce and finance.

Currency exchange rates determine the relative price of one nation's money against another, affecting everything from import costs and export competitiveness to investment returns and purchasing power. Understanding what drives these rates reveals why the Japanese yen weakened from 115 to 160 per dollar between 2021-2024, why the Turkish lira lost 44% in 2021 alone, and how traders profit from interest rate differentials through carry trades estimated at $350 billion globally.

Key Takeaways

• Interest rate differentials drive currency values as capital flows toward higher-yielding assets—a 1% rate increase typically strengthens a currency 3-5% over six months
• Inflation erodes purchasing power and weakens currencies, with hyperinflation cases like Venezuela seeing 99.99%+ currency devaluation
• Central bank policy actions (rate changes, quantitative easing, intervention) can move currencies 15-30% within 12-18 months
• Capital flows respond to economic growth differentials, with strong economies attracting foreign investment and strengthening their currencies
• The carry trade exploits interest rate gaps, with traders borrowing in low-yield currencies (JPY at 0.1%) to invest in high-yield currencies (AUD at 4.35%)
• Exchange rate theories like Purchasing Power Parity work over 3-5 year horizons but fail to predict short-term movements

How Interest Rates Drive Currency Values

Interest rate differentials create the strongest and most predictable force driving currency movements. Capital flows toward higher-yielding assets, increasing demand for currencies offering better returns. The Federal Reserve's 2022-2023 hiking cycle demonstrates this mechanism: 11 rate hikes bringing the federal funds rate from near-zero to 5.25-5.50% caused the Dollar Index to surge 18% in 2022's first ten months, pushing EUR/USD below parity (0.96) for the first time in 20 years and driving USD/JPY above 150—the weakest yen in 32 years.

The Carry Trade Mechanism

The carry trade represents the most direct way traders exploit interest rate differentials. Traders borrow in low-interest-rate currencies (funding currencies) and invest in high-interest-rate currencies (target currencies) to capture the spread. As of January 2026, the Bank of Japan maintains rates at 0.10% while the Reserve Bank of Australia holds rates at 4.35%—a 4.25% annual spread.

A trader borrowing ¥10,000,000 at 0.1% and converting to A$125,000 at an exchange rate of 80 JPY/AUD earns approximately A$5,625 annual interest while paying only ¥10,000 (≈A$125) on the loan—a 4.4% annual return before any currency appreciation. Popular funding currencies include JPY, CHF, and EUR (low yield), while popular target currencies include AUD, NZD, MXN, TRY, BRL, and ZAR (high yield).

The estimated size of the yen carry trade reached approximately $350 billion in short-term yen-funded loans globally. The August 2024 market volatility—when the Nikkei fell 12.4% in a single day—was partly attributed to carry trade unwinding after the Bank of Japan's surprise rate hike, demonstrating how quickly these positions can reverse.

Interest Rate Parity Theory

Covered Interest Rate Parity (CIRP) states that the difference between two countries' interest rates should equal the forward discount or premium between their currencies. The relationship follows this formula:

Forward Rate = Spot Rate × (1 + Domestic Rate) / (1 + Foreign Rate)

CIRP holds well empirically because deviations create risk-free arbitrage opportunities. If a US investor can earn 5% domestically or 3% in Europe, the forward rate must price EUR approximately 2% weaker than spot—otherwise arbitrageurs would exploit the discrepancy until prices converge.

Uncovered Interest Rate Parity (UIRP) predicts high-interest-rate currencies should depreciate to offset yield advantages. Empirically, UIRP consistently fails—high-yield currencies often appreciate, exactly opposite to predictions. This anomaly underlies the profitability of carry trades, as traders earn both the interest differential and often benefit from currency appreciation rather than the predicted depreciation.

How Central Bank Policy Impacts Exchange Rates

Central banks wield three primary tools that directly impact currency values: interest rate adjustments, quantitative easing or tightening, and direct currency intervention. Each tool operates through different mechanisms but ultimately affects currency supply, demand, and investor expectations.

Interest Rate Adjustments

Rate hikes attract foreign capital seeking higher returns, increasing currency demand and driving appreciation. The Federal Reserve's aggressive 2022-2023 tightening cycle provides a clear example: starting from near-zero rates in March 2022, the Fed raised rates 11 times to reach 5.25-5.50% by July 2023—the fastest tightening cycle in four decades. The dollar strengthened dramatically, with the Dollar Index gaining 18% in the first ten months of 2022.

Rate cuts reduce yield attractiveness, triggering capital outflows and currency depreciation. Turkey's 2021 "Erdoganomics" crisis exemplified this dynamic: President Erdogan forced the central bank to cut rates from 19% to 8.5% while declaring himself an "enemy of interest rates." The lira lost 44% of its value in 2021 alone, with official inflation hitting 85.5% (independent estimates suggested 150%+). The policy demonstrated how rate cuts during high inflation create a vicious cycle of currency weakness and accelerating price increases.

Quantitative Easing and Tightening

Quantitative easing (QE) expands the money supply through large-scale asset purchases, typically depreciating the currency as supply increases. The Bank of Japan's Quantitative and Qualitative Easing program launched in 2013 significantly weakened the yen, with USD/JPY moving from around 80 to 125 within two years. The European Central Bank's asset purchases peaked with an €8 trillion balance sheet, suppressing EUR values throughout the 2015-2021 period.

The mechanism works through multiple channels: QE lowers domestic interest rates (reducing yield attractiveness), increases money supply (reducing scarcity value), and signals accommodative policy (shifting investor expectations). The Bank of Japan's balance sheet reached 130% of GDP by 2022—the highest ratio globally—as the central bank purchased government bonds, ETFs, and REITs to maintain ultra-loose policy.

Direct Currency Intervention

Central banks occasionally buy or sell currency directly in foreign exchange markets to influence exchange rates. Japan's 2022 interventions provide a recent example: facing the yen's decline to 32-year lows above 150 per dollar, the Ministry of Finance spent approximately $60 billion in September-October 2022 buying yen and selling dollars. The yen strengthened temporarily by about 5%, but the effect proved short-lived as underlying interest rate differentials (Japan at 0% versus US at 4%+) continued driving yen weakness.

Successful intervention typically requires either massive scale, coordination with other central banks, or alignment with underlying fundamentals. The 1985 Plaza Accord demonstrated coordinated intervention's power: the G5 nations agreed to depreciate the dollar against the yen and Deutsche Mark, with the dollar falling 51% against the yen over the following three years from 242 to 120 JPY/USD.

How Inflation Affects Currency Values

Inflation erodes purchasing power and weakens currencies through multiple channels. Countries with higher inflation rates see their currencies depreciate relative to countries with lower inflation, as the real value of money declines faster. Relative Purchasing Power Parity (PPP) predicts that the percentage change in exchange rates should equal inflation differentials—if US inflation runs 5% while Japan's runs 1%, the dollar should depreciate approximately 4% against the yen over time.

Hyperinflation Case Studies

Zimbabwe's 2007-2009 hyperinflation reached peak monthly inflation of 79.6 billion percent in November 2008, with prices doubling every 24.7 hours. The $100 trillion Zimbabwe dollar note couldn't buy a bus fare. Three currency redenominations removed 25 zeros total before the Zimbabwe dollar was abandoned in April 2009. The causes included land reform destroying agricultural production (45% GDP drop), money printing for military operations, and political instability. Dollarization brought immediate stability, demonstrating how adopting a stable foreign currency can halt hyperinflation.

Venezuela's ongoing crisis (2016-present) saw hyperinflation exceed 1,000,000% annually by 2018 estimates. GDP fell approximately 80% from 2014-2025, with over 7.9 million refugees fleeing—one of history's largest migration crises. The bolivar lost 99.99%+ of value across two redenominations removing 14 zeros. By 2022, over 60% of transactions occurred in US dollars as Venezuelans abandoned the national currency. The causes included over-reliance on oil (90%+ of exports), price controls creating shortages, state oil company mismanagement, and international sanctions.

The Big Mac Index and Purchasing Power Parity

The Big Mac Index, published by The Economist, provides a simplified PPP test using the price of McDonald's Big Mac burgers across countries. In January 2025, a Big Mac cost $5.69 in the US versus £4.19 in the UK, implying a PPP exchange rate of $1.36/£ compared to the actual market rate of approximately $1.25/£—suggesting the pound was undervalued by roughly 8% according to PPP.

PPP fails in the short term due to non-traded goods (services can't be arbitraged internationally), sticky prices, trade barriers, and product differentiation. Research shows PPP deviations have half-lives of 3-5 years—too slow for trading strategies but useful for long-term currency valuation. The theory works better over decades than months, as short-term capital flows, speculation, and policy changes overwhelm gradual price adjustments.

How Capital Flows and Economic Growth Drive Currencies

Capital flows respond to economic growth differentials, investment opportunities, and risk perceptions. Strong economic growth attracts foreign direct investment and portfolio investment, increasing demand for the domestic currency. Countries with robust GDP growth, stable institutions, and attractive investment opportunities typically see currency appreciation as international capital flows inward.

Foreign Direct Investment Effects

Foreign direct investment (FDI) creates sustained currency demand as companies establish operations, build facilities, and hire workers. The United States attracted $285 billion in FDI inflows in 2022, supporting dollar demand. China's economic rise from 2000-2020 saw massive FDI inflows averaging $150 billion annually, contributing to the yuan's gradual appreciation from 8.28 per dollar in 2005 to 6.05 in 2014 before capital controls and economic slowdown reversed the trend.

Portfolio Investment and Capital Flight

Portfolio investment (stocks and bonds) moves more quickly than FDI and can reverse rapidly during crises. The "taper tantrum" of 2013 demonstrated this volatility: when the Federal Reserve signaled it would reduce bond purchases, emerging market currencies from the Brazilian real to the Indian rupee fell 10-20% within months as portfolio capital fled back to US assets.

Capital flight during crises can devastate currencies. Argentina's 2018 crisis saw the peso lose 50% of its value as investors withdrew capital amid fiscal concerns and IMF negotiations. The country's history of defaults (nine since independence) and inflation crises makes it particularly vulnerable to confidence shocks that trigger rapid capital outflows.

How Market Structure and Speculation Influence Rates

The foreign exchange market's decentralized structure and 24-hour operation create unique dynamics that amplify or dampen fundamental forces. Market participants form a tiered hierarchy: major commercial banks (market makers) constitute approximately 80% of money flow, other financial institutions represent 48% of turnover, while non-financial customers account for just 6% and retail traders make up the remainder.

Geographic Concentration and Trading Sessions

Geographic concentration creates predictable liquidity patterns. The United Kingdom handles 38% of global FX trading, followed by the United States at 19%, Singapore at 9%, Hong Kong at 7%, and Japan at 4%. London's dominance stems from its position overlapping both Asian and New York sessions, creating the highest liquidity window during the 1:00-5:00 PM UTC overlap when both major centers are active.

Bid-ask spreads reflect this liquidity variation. Major currency pairs like EUR/USD trade with spreads of 0.5-2 pips during peak hours, widening to 2-5 pips during low-liquidity Asian sessions. Minor pairs like EUR/GBP maintain spreads of 2-5 pips, while exotic pairs like USD/TRY or USD/ZAR can see spreads of 10-100+ pips depending on market conditions.

Speculative Positioning and Momentum

Hedge funds and proprietary trading firms account for approximately 7% of turnover but can move markets with billion-dollar positions. George Soros's famous 1992 bet against the British pound—forcing the UK out of the European Exchange Rate Mechanism—demonstrated how large speculative positions can overwhelm central bank intervention when fundamentals support the trade. Soros reportedly made over $1 billion as the pound fell 15% in a single day.

Momentum trading and technical analysis create self-reinforcing trends as traders follow price patterns. When EUR/USD breaks through key technical levels like 1.10 or 1.05, algorithmic trading systems (now accounting for approximately 25% of volume) can amplify moves as stop-loss orders trigger and momentum strategies enter positions.

Conclusion

Currency exchange rates respond to a complex interplay of interest rate differentials, inflation trends, capital flows, central bank policy, and market sentiment. Interest rate changes create the most predictable force, with a 1% rate increase typically strengthening a currency 3-5% over six months as capital flows toward higher yields. The Federal Reserve's 2022-2023 hiking cycle demonstrated this mechanism, pushing the dollar 18% higher in ten months as global capital sought US assets offering 5%+ returns.

Understanding these forces reveals why the carry trade remains profitable despite violating Uncovered Interest Rate Parity, why hyperinflation destroys currency values by 99%+ as seen in Zimbabwe and Venezuela, and why central bank intervention often fails without alignment to underlying fundamentals. Exchange rate movements ultimately reflect the collective judgment of $7.5 trillion in daily trading volume—market participants voting with capital on which economies offer the best combination of growth, stability, and returns. For businesses managing foreign exchange exposure and investors allocating capital globally, recognizing these fundamental drivers provides essential context for navigating the world's largest and most liquid financial market.

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