What influences exchange rate fluctuations?

There are many factors which affect exchange rates but there are three main forces which drive exchange rates; 1) Purchase Power Parity or PPP. This says that in the long run the exchange rate between two currencies will equate the two price levels in the respective economies. Now this means that if a 'basket' of goods in the USA is equal to $2 and the same basket in the UK is equal to £1 then the exchange rate should be £1:$2 because then there will be purchase power parity. Empirically PPP only seems to hold over the long term (as long as 10 years) and so is not as relevant in the short-term. 2) Interest rate parity. This one says that the exchange rate should reflect the difference between interest rates in the two economies. For example if to start with interest rates in the US are 5% and 4% in the UK, but then the UK interest rate falls to 3% the pound must fall against the dollar because to make up for the lower rate of return on the currency investors will discount the value ...  more