What Drives the Exchange Rate?Some of the factors influencing a currency's exchange rate (relative to another currency) are; balance of trade, economic growth, interest rate differentials, inflation, political stability and speculation, as discussed below.
Balance of Trade
If a country is a net exporter, then, effectively, its currency is in demand and the laws of supply and demand will prevail, pushing up the value of the currency. We saw this in the worldwide commodities boom, roughly from 2003 to 2013, when the price of iron ore, for example, rose from below $20 USD/tonne to well over $150 USD/tonne.
Australia is a major exporter of iron ore and other commodities and consequently, the Australian dollar appreciated considerably - for example, the AUD/GBP rate dropped from about 2.8 to 1.47 over the same period.
Basically for the same reasons as above (Balance of Trade), when global economic growth rises, so do the 'growth' currencies - eg. the Australian dollar. When growth drops, it puts downward pressure on the growth currencies.
If a country has a relatively high official interest rate, investors are more likely to buy it, therefore driving up the exchange rate. Over the last 10-15 years, Australian interest rates have consistently been about 2% higher than UK interest rates.
Inflation has the effect of eroding a currency's real value, so has a lowering effect on the exchange rate. In recent times, most western countries have experienced low inflation, so this has not been a major driver on exchange rates.
Instability, either within a country or globally, can have an effect on exchange rates. In recent times, major destabilising events (wars, terrorism etc) produce a run from 'risky' currencies to 'safe' currencies. Broadly speaking, the US dollar is still seen as a safe currency, whereas the Australian dollar is a 'risky' currency.
The factors listed above are taken into account by currency traders, when they decide which currencies to buy and sell and what to pay for them. Naturally, there will be a large amount of speculation involved in doing these deals, as the traders attempt to guess which way the rates are going to go.
Sometimes, the rates seem to move contrary to all the available information, maybe because of a rumour or some other expectation in the marketplace.