What Factors Mainly Determine Foreign Exchange Rates?

In the foreign exchange market, what economic factors determine exchange rates, and what causes them to change?

To answer this question, we must start by analyzing the foreign exchange market.
The foreign exchange market, as the name suggests, is where currencies from different countries are exchanged, and exchange rates are determined here. Like other markets, the forex market is primarily influenced by two key factors: the supply and demand of currencies, and the price of each currency, which is denominated in its own national unit.

Despite the various types of transactions in the forex market, the fundamental principle behind exchange rate determination remains the same. Many economists prefer to explain forex market dynamics using supply and demand relationships.

The American economist Paul Samuelson once used supply and demand curves to analyze how exchange rates are determined in the market. His example focused on bilateral trade between the British pound and the US dollar. The demand for pounds in the US arises from British exports of goods, services, and investments to America, requiring dollars to be exchanged for pounds to make payments. The supply of pounds, on the other hand, depends on US exports of goods and services to the UK, as well as American investments there. The price of foreign exchange—the exchange rate—is set at the point where supply and demand balance. The equilibrium between supply and demand in forex transactions determines currency exchange rates.

This supply and demand dynamic exists for every currency, with influences coming from all corners of the world. This multilateral exchange system collectively determines global exchange rates.