What are the factors affecting Exchange Rates?

We often hear about exchange rates moving when major world events take place, but what other factors are at play?

Movements in exchange rates happen because of several influences that interplay with each other. Understanding these influences allows us to see the key trends and can help businesses to create a risk management strategy to deal with them.

Interest rates and inflation: together they influence market movements

The role of interest rates

Given how important the role of interest rates is for a country’s economy and the way that central banks use them to influence inflation, it is not surprising to see them included.

To what extent they influence exchange rates is more nuanced and it is also important to consider their impact on inflation:

• A lower interest rate increases the chance of inflation, as it is cheaper to borrow money. When people borrow more, they also tend to consume more and are less likely to save. This creates upward pressure on prices.
  
  

• A higher interest rate does the opposite as it encourages people to save. It can increase a currencies value because it attracts overseas investment.

Although there is a correlation between interest rates and exchange rates, their impact alone is never a certainty and given its close correlation with inflation, it’s important to look at them together.

What impact does inflation have on exchange rates?

Lower levels of inflation, given they are stable, generally have a positive impact on the value of a country’s currency. Although the impact of inflation tends to be negative, some inflation can be good for a country’s economy, provided:

• There is an adequate interest rate response, typically the central bank will raise interest rates. This can result in an increase in foreign capital chasing higher returns.
  
  

• Inflation is stable and predictable (for example many governments target around 2%, this can even be beneficial for economic activity.
  
  

• But if inflation does increase too quickly and is not appropriately managed, then it becomes hyperinflation.

Hyperinflation is incredibly destabilising for a currency and therefore reduces its buying power.

In simple terms, it makes imports very expensive and the cost of living unaffordable. It can lead to extreme depreciation of a currency, to the point when it’s no longer worthwhile to hold.

There are many historical examples where this has happened, extreme cases include; Venezuela and Zimbabwe.

In Zimbabwe’s case, hyperinflation led to the replacement of the Zimbabwe dollar with the Zimbabwean Gold (ZWG) in April 2024, after Zimbabwe’s inflation rate hit 55.3% only the month before in March.

• Very low inflation (e.g. 0%) and deflation is equally problematic, as people stop spending as they normally would.

Caption: Two Japanese men stand in front of boards showing the stock market

One of the most well-known examples of the impact of deflation on a currency is a phenomenon known as The Lost Decades in Japan (spanning 30 years). Several factors led to the Lost Decades, including an aging population and economic policy, which caused the Japanese yen to be extremely volatile.

Political stability and currency value

Political certainty is undoubtedly another influential factor. Currencies such as the Swiss franc achieve “safe haven” status, thanks to the stability of the country, notably increasing its value.

However, this can start to cause problems for the economy and can make exports very expensive if not well managed.

But when uncertainty increases, which we see during major political or geopolitical events, exchange rates can become more volatile. We saw this when the US dollar fell sharply in 2025.

Its biggest contributing factor was the introduction of the US tariff policy, which challenged the consensus that there would be strong growth after the re-election of Donald Trump in 2024.

The element of surprise increases the impact: for example, after the leave campaign won the Brexit referendum, at great shock to the British public and politicians alike, the British pound fell sharply. It hit a 31-year low and dropped by nearly 10% against the US dollar in a short period. This was not the expected outcome and markets reacted strongly to the UK’s uncertain future.

Market movements sometimes precede real events

Markets often react in advance to anticipated changes in interest rates, economic data or policy decisions.

Monetary Policy Committee meetings, where interest rate changes are announced are an example of this, as traders will often start buying a currency before any official decision is made. Therefore, exchange rates will also begin to move as a result.

But without the element of surprise, as was the case of Brexit, the effect is typically less pronounced.

Balance of trade deficit and its impact on currencies

A country’s global trading relationship is also important and typically, countries with a trade surplus, meaning that they export more than they import have stronger currencies.

And vice versa: when a country imports more than it exports, it needs more foreign capital than it gets from exports. The country could potentially sell its own currency to buy other currencies, resulting in a growing surplus of local currency that isn’t being used, leading to a build-up in foreign accounts. These factors lead to the devaluation of that currency.

Managing exchange rate impact

Despite the number of factors that impact exchange rates, their level of influence varies from market to market and are not easy to predict. You could watch rates closely and try to choose the best time to exchange currencies, but this isn’t without risk, as even professional forex traders get this wrong sometimes.

Risk management solutions such as forward contracts, non-deliverable forwards and options are some of the methods that businesses use to mitigate the impact of exchange rate movements. They allow you to have more certainty in an ever-changing market, without having to constantly watch it.