A currency exchange rate will change any time the market-based value of either currency changes. Like any other product affected by the laws of supply and demand, these rate changes are caused by increased or decreased demand for one of the currencies.

Typically, demand for a currency will increase due to increased transaction demand, the need for a currency to accommodate business activities, or an increased speculative demand. Transactional demands can be relatively easily predicted by economists, and because of this predictability, central banks have little trouble keeping their currencies stable.

On the other hand, speculative currency trading can have a large effect on a currency’s exchange rate when traders believe they can make money by buying or selling a currency based on the best currency exchange rate. Speculators can greatly affect currency value, and undermine economic growth, by shorting a currency, driving down its price and then purchasing it at a lower rate. It is difficult for central banks to manage this type of currency trading and keep exchange rates stable.

Can countries gain market advantage by manipulating currency markets?

Countries can attempt to boost export of domestic goods by manipulating exchange rates and keeping their currency artificially low. This has the effect of gaining a market advantage by making their domestically-produced goods cheaper to buy for trading partners.

China has been accused of manipulating the value of the yuan to make Chinese goods cheaper for North American and European buyers, thus making Chinese companies more competitive. The contra side to this type of currency manipulation is that imported goods and foreign travel become more expensive for domestic consumers to access.

In a currency manipulation scenario, a country’s central bank “prints” its own currency, rather than purchasing it on the open market. For example, when US consumers purchase Chinese goods in dollars, the Chinese exporters sell these dollars to their own Chinese bank in order to convert them to yuan. This creates a shortage of yuan holdings by the central bank, which has to be corrected. However, rather than sell those dollars back on the international currency exchange market to buy more yuan, the Chinese bank simply “prints” more yuan and keeps the dollars.

It is because of this that the Chinese government is presently sitting on a large cache of US dollars. If they were to release many of these dollars back into global currency markets, we would see the price of the US dollar fall. This again is because of the supply and demand rule. More USD on the market eases demand and lowers the price. At this point, the US Fed might attempt to buy up many of the US dollars on the market in an attempt to restore the value of the dollar.

These activities are some of the primary causes of exchange rate fluctuations.