What drives exchange rates?
Macro reasoning across interest rates, inflation, growth and flows.
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In the short run, mostly interest-rate differentials and expectations of central-bank policy — higher expected rates attract capital and strengthen a currency — plus risk sentiment, with safe havens like the dollar, yen and Swiss franc rising in a crisis. Over the longer run, relative inflation (purchasing power parity), growth and productivity, the current account and public finances matter.
The full answer
| Driver | Effect on the currency |
|---|---|
| Higher interest rates (relative) | Stronger — more attractive to hold |
| Higher inflation (relative) | Weaker over time — loses purchasing power |
| Stronger growth | Usually stronger |
| Current-account surplus | Supports the currency |
| Large deficits and debt | Weaker, risk premium |
| Risk-off episodes | Safe havens strengthen |
| Political risk | Weaker |
Theories
- Purchasing power parity: exchange rates move to equalise prices — a long-run anchor.
- Interest rate parity: forward rates reflect interest differentials.
In practice, flows and positioning dominate day-to-day moves.
Mistakes to avoid
Saying high inflation strengthens a currency because rates rise — the net effect depends on real rates.
Follow-ups they may ask
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