The major influence on the exchange rate is the supply and demand of money. When companies buy services and products from other countries, they must first exchange their national currency for the currency of the country providing the product or service. The price of that money is, effectively, the exchange rate. Therefore, when the demand for the money of a certain country goes up, its price generally rises accordingly.
When the demand and price of one currency rises, it often causes a depreciation in another currency. For example, if the United States begins to buy a large amount of products from Japan, the demand increases and so does the price of yen. At the same time, more U.S. dollars are put in the international market to buy the yen that allow the purchase of the products. This rise in the supply of U.S. dollars causes them to drop in price, or to depreciate.
Several factors can increase the demand for certain currency. If imported products are offered at a lower price than the domestic version of the product, demand rises. If a domestic version of a product is not available, demand rises. If another country offers a better return on investment, demand can rise as domestic citizens invest in foreign securities. Inflation rates also affect demand; if a certain country's rate of inflation is higher, investors are less likely to choose its currency.
The exchange rates tend to be cyclical because of imports and exports. When the domestic currency is strong, imports seem cheaper. Exports, however, do not fare as well because foreign countries view products as more expensive. However, as imports increase from a certain country, that country's currency increases in value and the domestic currency decreases; exports then become more popular.
Exchange rates significantly affect worldwide commerce and can be reactive to the perceived strength of individual economies. If a foreign country or countries in the world market believe that the economy of Canada will not remain strong, for example, they are less likely to invest in Canadian securities and the Canadian dollar can depreciate. Exchange rates also affect the well-being of domestic importers and exporters as the demand for their products increases and decreases.
