It's tempting to think of a currency's exchange rate as a kind of report card on the underlying economy — a strong economy gets a strong currency, a weak one gets a weak currency. That's not quite how it works. An exchange rate is a price like any other, determined in a currency market by supply and demand for that specific currency relative to others, and while economic strength is one influence on that supply and demand, it's far from the only one, which is why exchange rates can move sharply on news that has little direct connection to how healthy the underlying economy actually is.
Demand for a currency comes from wanting what it can buy
Demand for a given currency comes from anyone who needs to hold it for some purpose: foreign buyers purchasing that country's exports need its currency to pay for them, foreign investors buying that country's assets, bonds, or real estate need its currency to do so, and speculators betting the currency will rise in value want to hold it now to profit later. Supply comes from the mirror-image transactions: domestic buyers needing foreign currency to buy imports, domestic investors buying foreign assets, and so on. Just like the price of any traded good, a currency's exchange rate moves toward whatever level balances how much of it people want to buy against how much people want to sell, at that moment.
Interest rates and expectations often move markets faster than economic fundamentals
Because currency markets are forward-looking and highly liquid, exchange rates often respond quickly and strongly to changes in expectations, particularly around interest rates: a country raising interest rates tends to attract foreign investors seeking higher returns on that country's currency-denominated assets, increasing demand for the currency and pushing its value up, independent of whether the underlying economy's real productive strength has actually changed at all. Central bank announcements, shifts in expected future interest rate policy, and even rumours about upcoming policy changes can move exchange rates significantly within minutes — a reminder that an exchange rate reflects the balance of a currency market's supply and demand at a given moment, shaped by expectations about the future as much as by the current health of the underlying economy, not a direct, real-time scorecard of economic fundamentals themselves.
What we're still unsure about
The basic supply-and-demand mechanics of currency markets, and the strong influence of interest rate expectations on exchange rate movements, are well established in economics and consistently observed in real financial markets. What remains genuinely difficult, and a persistent challenge in international economics, is predicting exchange rate movements over any meaningful time horizon — currency markets are influenced by an enormous number of interacting factors, expectations, and feedback loops, and economists have had limited success building models that reliably outperform simple guesses at forecasting where a given exchange rate is actually headed next, even though the underlying mechanics of what moves it in any given moment are reasonably well understood.
This sits inside Exchange Rates & Currency Markets, one of seven topics in Trade, one of five domains in Economics, one of seventeen subjects the app can quiz you on.