Why do currencies fluctuate relative to another?

We generally read that the Rupee has appreciated (strengthened) or depreciated (weakened) with respect to another currency, say, the Dollar or Euro. So what causes this rise and fall?

An exchange rate is simply the price of one currency in terms of another. As prices at a very basic level, are influenced by laws of supply and demand in the marketplace. Higher demand translates to a higher price. Higher supply wrt demand eventually drives down the price. But what factors control the supply and demand? Let’s discuss few important ones.

1. Interest Rates

Interest Rate, announced by a country’s central bank periodically, is the rate of interest offered for buying up sovereign bonds. This is how a country raises up more debt – by selling more bonds and offering interest rates on them. So when a country, aided by the central bank, offers higher interest rate, it attracts more investors who are always looking to earn higher returns for their investments. Higher capital inflows drive up the value of the country's currency and we say that the domestic currency has appreciated wrt foreign currency.

2. Current Account Balance

Current Account of a country records the value of exports and imports of both goods and services and international transfers of capital. Let’s say, today Indian consumers develop a huge appetite for French wine. This increased demand for French wine would translate to increase demand for Euros needed to buy them. As demand for Euros increases, the price of Euros relative to the Rupee increases and we say that the Rupee has depreciated, and Euro has appreciated.

Now let’s look into the financial markets. Suppose foreigners have developed an enormous appetite for the IPOs of buoyant Indian Startups. So, these foreigners will try to buy these financial assets using the local currency, increasing demand for the Rupee and thus increasing its price relative to the foreign currency. 

Since investors can sell financial assets in a moment, the money can leave the nation quickly as well. Thus sometimes FII inflow is also referred to as "hot money". FDI is considered a more stable form of investment from a domestic country's perspective.

It is not important whether a country’s Current Account is in Surplus or in Deficit. What matters are the factors driving this surplus or deficit. Is it demand for goods or services or the demand for capital?

Increased demand for a country’s goods and services will drive up Current Account Balance and Currency.

Increased demand for a country’s financial capital will drive down the Current Account Balance but will bolster the currency.

3. Inflation

Inflation is defined as the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country.

Rising prices in India (higher Inflation) will make imports from US or France (lower inflation) seem attractive. As a result, the higher demand for foreign goods will translate to a higher demand of foreign currencies and drive up the prices wrt the local currency.

Hence, we see that a country with consistent higher inflation has its currency depreciate in value over time.

While these are the 3 main factors affecting a nation’s currency, the currency markets are unpredictable and explaining FX market moves coherently is difficult even for the most learned traders. The role of the sentiments of the masses, which might not be always rationale,  also has  a big say in this.