Anything that raises demand for the currency causes appreciation. Anything that raises supply of the currency causes depreciation. Five families of cause matter.
1. Trade flows
- Rising exports. Foreign buyers need the domestic currency to pay → demand for the currency rises → appreciation.
- Rising imports. Domestic residents sell their currency to buy foreign currency → supply of the currency rises → depreciation.
A country with a strong export sector tends to have a strong currency; a country running a large current-account deficit tends to have a weakening currency.
2. Interest-rate differentials
- Higher domestic interest rates attract foreign investors looking for higher returns. They buy the currency to hold deposits or bonds → demand rises → appreciation.
- Lower domestic interest rates push investors out toward higher-yielding currencies abroad → supply rises → depreciation.
These short-term capital flows ("hot money") can move billions of dollars within days. They are why central-bank interest-rate decisions have such an immediate impact on exchange rates.
3. FDI and other capital flows
- Inward FDI (foreign firms buying or building assets in the country) raises currency demand → appreciation.
- Outward FDI (domestic firms investing abroad) raises currency supply → depreciation.
- Capital flight (investors rushing to leave for safer markets) is a fast and damaging form of depreciation.
4. Inflation differentials
- Higher domestic inflation (compared with trading partners) makes the country's exports less competitive in foreign markets. Exports fall, imports rise, trade deficit widens → depreciation.
- Lower domestic inflation does the opposite.
This is the long-run anchor of exchange-rate theory: in the long run, currencies of high-inflation countries tend to depreciate against currencies of low-inflation countries (a version of purchasing power parity).
5. Speculation and political stability
- Speculation. FX traders bet on future moves. If many traders believe a currency will fall, they sell it now, pushing it down (a self-fulfilling expectation).
- Political instability. Election uncertainty, war, government collapse all make investors sell the currency → depreciation.
- Central-bank intervention. Under a managed float or fixed peg, central banks buy or sell currency to influence the rate directly.