What makes currency of different nations go up and down in relation to each other?

Answer 1

The foreign country's demand for home currency relative to home demand for that foreign currency.

Currency is just like any other commodity: its price depends on supply and demand. The supply side comes from the government's printing press. Assuming supply stays constant (not always, governments can always print more money, or buy more bonds in return for returning more dollars into the economy), then demand is the most important factor.

Say we have the US and China.

The US is importing more from China than China is importing from the US. We have to pay China in Yuans, their home currency, and we do this by giving them our Dollars for their Yuan. The more Yuan we demand, the more they charge us in dollars. (because they can afford to do this).

Now normally, what happens is that if the US is importing more than we are exporting with reference to a country like China, then their currency rises relative to ours (that is, it costs us more to buy Yuan than it costs them to buy dollars). But China's central bank can tinker with its currency by officially giving us Yuan at cheaper than market values. They do this because it keeps Chinese imports cheaper than they normally should be, and this helps their export sector. This is precisely what China has been doing (that's why Walmart prices are so low).

Besides exports, financial investments also play a role in the exchange rate. If China invests more of their Yuan in the US, by first exchanging for dollars, then this works in the reverse, increasing demand for dollars. Of course, with such a large surplus of dollars from the US in their trading sector, China normally just invests dollars directly from their surplus.

The so-called "law of one price" states that as money and goods can trade rapidly from one nation to another, price differences for goods become small once accounting for exchange rates. For example, a Big Mac should cost about the same, once we exchange our currency for the foreign currency. The Economist actually publishes this data, and while the Big Mac is cheaper in some places than others (Japan is notoriously expensive while Argentina is dirt cheap), Big Macs are about the same price once we account for the exchange rate.

Some people try to benefit from price arbitrage. Say Country A's currency is worth 2 of B's, B's currency is worth 1/2 of C's, but C's is worth 3/4 of A's. Can you profit from this difference? Yes. First, take A and convert to C. This gives you, for each dollar, 4/3 or 1.333C. For each C, you get 2*1.333=2.6666 B. Now, just convert back to A and you get 2.66666/2=1.3333 A. Notice that by simply exchanging the currencies between each other, we start with 1 dollar and end up with 1.3333, a 33% profit. All of this is possible because of price distortions. Arbitrage is usually so fast that the example I gave you almost never happens. But at the margins, there are tiny differences and peple who day trade in forex (foreign exchange) can earn big money from arbitrage. (they can also LOSE big money).

Answer 2

Many things. Perceived investment returns and risks are a large factor. The balance of trade is a factor. Inflation is an issue. All in all, it is a huge market, trading over a trillion dollars every day.