Hey Lykkers! You've checked the exchange rate for your next trip, and it's different from last year. Or you see headlines about the dollar "soaring" or the yen "collapsing." It can seem random, driven by daily news and trader sentiment. But zoom out. Over years and decades, currency values don't drift aimlessly.

They're steered by powerful, fundamental forces. Forget the daily noise for a moment. Let's uncover what really drives exchange rates in the long run.

Think about this: a smartphone or a car should, in theory, cost roughly the same everywhere once you account for the exchange rate. This common-sense idea is the heart of Purchasing Power Parity (PPP).

In the long run, currencies adjust so that a basket of identical goods has equal value across countries. If a country has persistently high inflation (like prices for food, rent, and services rising fast), its currency must eventually depreciate to restore that balance. As Nobel laureate economist Paul Krugman explains in his writing on international economics, "In the long run, exchange rates move to offset differences in inflation rates between countries" (Krugman, International Economics). This is why the money of countries with runaway inflation loses value over the long haul. For a tangible, if unorthodox, test of this principle, see The Economist's famous burger benchmark, which uses the global price of a fast-food sandwich to gauge whether currencies are over or under-valued.

The Productivity Engine & Terms of Trade

A country's economic muscle is a core driver. Nations that become more productive—producing better goods and services more efficiently—tend to see their currencies strengthen over time. Why? Because the world wants their high-quality exports, demanding their currency to pay for them.

This connects directly to Terms of Trade. If the price of a country's major exports (like oil for Norway or tech for South Korea) rises relative to the price of its imports, it earns more foreign currency. This improved trade balance creates natural, sustained demand for its currency, pushing its value up. A sustained decline in export prices can have the opposite effect.

The Interest Rate Magnet (It's About Real Rates!)

Yes, interest rates matter hugely, but there's a key nuance. It's not the headline rate you see, but the real interest rate—the nominal rate minus inflation.

The Debt & Deficits Question

Finally, we have government finances. A country that runs large, persistent budget and trade deficits is, in essence, spending more than it earns and borrowing from abroad. This can lead to a buildup of foreign debt. Over the very long term, markets may lose confidence, demanding a higher risk premium or a weaker currency to fund that deficit. It’s a slow-burn pressure, not an immediate trigger, but it sets a direction. The currency of a nation seen as fiscally reckless will face a persistent headwind.

So, Lykkers, while day-to-day moves are driven by news and sentiment, the long-term path of a currency is a report card on a nation's economic health: its inflation discipline, productivity, real returns on capital, and fiscal sustainability. It's not a mystery—it's economics in motion.

Want to dive into the wild short-term drivers next? Let us know!