Exchange rates are determined by supply and demand. For example, if there will be greater demand for American goods then there will tend to be an increase in value of the dollar. If markets will worry about the future of the US economy, they will tend to sell dollars, leading to a fall in the value of the dollar. Currency changes affect you, whether you are actively trading in the foreign exchange market. When it comes to the decision of whether you should buy or sell dollars, it all boils down to how the economy is performing. A strong economy will attract investment from all over the world due to the perceived safety and the ability to achieve an acceptable rate of return on investment.
Most important factors deriving exchange rates:
Inflation plays an important role.
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.
Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. Interest rates from central banks influence the retail rates financial institutions charge customers to borrow money. For instance, if the economy is under-performing, central banks may lower interest rates to make it cheaper to borrow; this often boosts consumer spending, which may help expand the economy. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates.
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency and increase in the country?s currency value and vice-versa.
We all knew that in the short run, interest rates and currency valuations are often correlated. Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. Reason is, a large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
These above factors are most important to determine country?s currency power. In trading exchange rate of two currency pairs is most important to decide either to buy or sell.