What drives exchange rates
Multiple forces push and pull currencies simultaneously. Interest rate differentials: higher interest rates attract foreign capital (investors seeking better returns), increasing demand for the currency and pushing it up. Inflation: a country with higher inflation sees its currency weaken over time — the purchasing power parity (PPP) theory suggests exchange rates should adjust to equalise price levels. Current account balance: a country that imports more than it exports creates net demand for foreign currency, weakening its own. Political risk and confidence: the UK’s experience in September 2022 demonstrated how quickly a currency can fall when policy credibility collapses.
Fixed vs floating exchange rates
Most major currencies today operate on a floating regime — their value is determined by market forces and fluctuates continuously. Some countries peg their currency to another (Saudi Arabia pegs the riyal to the USD, Hong Kong pegs the HKD to the USD). Pegs require the central bank to hold large foreign exchange reserves to defend the rate. When reserves are insufficient and the peg becomes unsustainable, the result can be a currency crisis — as seen in the UK’s ERM crisis of 1992 ("Black Wednesday"), the 1997 Asian financial crisis, or Argentina’s repeated peso collapses.
Exchange rates and everyday impact
A weaker pound is inflationary: imported goods (oil, food, electronics) cost more in sterling terms. UK manufacturers become more competitive abroad (their goods are cheaper for foreign buyers) but their imported inputs are more expensive. A stronger pound is disinflationary: imports are cheaper, but UK exports become pricier. This is why the Bank of England watches sterling closely — a sharp depreciation can import inflation even if domestic conditions are stable. For travellers, exchange rate swings matter acutely: GBP/USD moving from 1.40 to 1.20 makes a $200 hotel cost £167 instead of £143.
“Exchange rates are prices. Like all prices, they are set by supply and demand. Unlike most prices, they are simultaneously the price of a country’s economic credibility.”
What this means for you
Exchange rates affect you even if you never travel abroad. They determine import prices, which feed into your cost of living. They affect the returns on international investments (a US stock rising 10% may deliver a smaller sterling return if the dollar weakens). When sending money abroad (remittances, international transfers), avoid airport bureaux de change and bank transfers at standard rates — services like Wise (TransferWise) typically offer rates within 0.5% of the interbank rate, versus 3–5% from high-street banks. The bid-offer spread charged to retail customers is a real cost that compounds on large amounts.