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As Country A’s price level and import demand increase, and as Country A’s productivity, trade barriers, and export demand decrease vis-à-vis another Country B, Country A’s currency depreciates and Country B’s appreciates.
Basically, anything that lowers demand for Country A’s goods, services, and currency induces the currency to depreciate; anything that increases demand for Country A’s stuff induces the currency to appreciate in response.
Higher inflation relative to Country B makes Country A’s stuff look more expensive, lowering demand and inducing depreciation.
If economic actors in Country A take a fancy to Country B’s stuff, they will import it even if Country A’s currency weakens, making Country B’s stuff more expensive. Reductions in trade barriers (lower tariffs, higher quotas, fewer NTBs) will exacerbate that.
If, for whatever reason, economic actors in Country B don’t like Country A’s stuff as much as they used to, they’ll buy less of it unless Country A’s currency depreciates, making it cheaper.
Finally, if Country A’s productivity slips relative to Country B’s, Country A’s goods and services will get more expensive than Country B’s so it will sell in Country B only if its currency depreciates.
Because foreign exchange markets are efficient, in the short run, the mere expectation of changes in relative inflation, exports, imports, trade barriers, and productivity moves the markets.
Also in the short run, differences in interest rates and expectations of the future exchange rate play key roles in exchange rate determination.
The interest parity condition equates the domestic interest rate to the foreign interest rate minus the appreciation of the domestic currency. (Or, by rearranging the terms, it equates the foreign interest rate to the domestic interest rate plus the expected appreciation of the domestic currency.)
The interest parity condition holds whenever there is capital mobility, whenever deposits (units of account) can move freely and cheaply from one country to another.
It holds under those conditions because if it didn’t, an arbitrage condition would exist, inducing arbitrageurs to sell the overvalued deposit (side of the equation) and buy the undervalued one until the equation held.
The market for foreign exchange can be modeled in many different ways.
The easiest way, perhaps, is to think of the price of a domestic currency, say, USD.
There is a given quantity of USD that is insensitive to the exchange rate.
Demand for the domestic currency slopes downward for the usual reasons that economic actors demand more of an asset when it is cheaper.
The intersection of the two lines determines the exchange rate.
Creative Common
Good points again, forex can be a great tool if properly used. It does take some learning to become a pro, like anything else, nice blog and thanks for the read.