Why do exchange rates change?

An exchange rate is the price of one currency in terms of another. When a currency floats (the government doesn't fix its price), demand and supply set the price, just like in any other market.

Demand for a currency comes from people and firms abroad who need it. They might be buying the country's exports, visiting as tourists or putting money into its banks and businesses. Supply comes from people and firms at home who need foreign currency. They sell their own currency to pay for imports, travel abroad or invest overseas.

Anything that changes these flows moves the exchange rate. If a country's interest rates rise compared with other countries, more foreign savers want to hold its currency. Demand rises and the currency appreciates, which means its value goes up. If a country's inflation is higher than in other countries, its exports become less competitive. Demand for its currency falls, so the currency tends to depreciate (fall in value). Expectations matter too. If traders think a currency will rise, they buy it now, and that pushes the price up.

Exchange rate changes affect exports and imports. When a currency depreciates, the country's exports become cheaper for foreign buyers, and imports become more expensive at home. So exports may rise and imports may fall. An appreciation has the opposite effect. Remember one side effect of a depreciation: imported fuel and materials cost more, so firms' costs rise, and this can lead to cost-push inflation.

How much trade changes depends on price elasticity of demand. If demand for exports and imports is price inelastic, the amounts bought change very little. Two ideas on this are A Level only. The Marshall-Lerner condition tells you when a depreciation improves the current account. This happens if the price elasticities of demand for exports and imports add up to more than one (ignoring the minus signs). The J-curve shows that the current account may get worse at first and then improve, because buyers take time to change what they buy.