A. Why exchange rates change

An exchange rate is the price at which one currency can be exchanged for another (e.g. how many yen are needed to buy a euro). In theory, exchange rates should be at the level that gives purchasing power parity (PPP). This means that the cost of a given selection of goods and services (e.g. a loaf of bread, a kilowatt of electricity') would be the same in different countries. So if the price level in a country increases because of inflation, its currency should depreciate - its exchange rate should go down in order to return to PPP. For example, if inflation increases in the US, the dollar exchange rate should go down so that it takes more dollars to buy the same products in other countries.

In fact, PPP does not work, as exchange rates can change due to currency speculation - buying currencies in the hope of making a profit. Financial institutions, companies and rich individuals all buy currencies, looking for high interest rates or short-term capital gains if a currency increases in value or appreciates. This means exchange rates change due to speculation rather than PPP. Over 95% of the world’s currency transactions are purely speculative, and not related to trade. Banks and currency traders make considerable profits from the spread between a currency’s buying and selling prices.