Think for instance of the car selling business in a small village. At first there will be just a few car vendors. As the village grows, more and more people will need cars to satisfy their needs, pushing up the demand for cars. At this point the demand for cars is greater than the quantity supplied, pushing prices up. As people realize selling cars is such a great business opportunity, more people will be attracted the car business and will start selling cars. As this happens, more and more cars will be available, pushing up the supply of cars. At some point, the supply will be greater than the demand of cars. If car vendors don't lower their prices, they won’t be able to sell their cars, so they are forced to lower them.
The same goes for currencies, when a currency increases its value, the demand is greater than its supply. When a currency decreases its value, its supply is greater than its demand.
What factors influence the supply and demand of one currency?
The two main factors that influence the movements in one exchange rate are:
1. The capital flows
2. The trade flows
These two components constitute what economics call balance of payments. The main purpose of the balance of payments is to quantify the demand and supply for a currency of one country, over a period of time.
Balance of Payments = Capital Flows + Trade Flows
A negative balance of payments indicates that the capital leaving the country is greater than the capital entering the country (not much demand)
A positive balance of payments means that the capital entering the economy is greater than the capital leaving the economy (increasing demand of the domestic currency)
Theoretically, a balance of payments equal to zero indicates the right value of one currency.
Capital flows is the net quantity of currency traded (bought or sold) through capital investments.
The capital flow can be divided into: physical flows and portfolio investments.
Physical Flows - They happen when foreign entities sell their local currency and buy foreign currency to make foreign direct investments (for joint ventures, acquisitions, etc.) When the volume of this kind of investment increases, it reflects the good shape and health of the economy where it is invested.
Portfolio investments - These are investments made on global markets, variable and fixed income market investments (Forex, stocks, T-bills, etc.) An example of portfolio investments is when a hedge fund in Japan invests in the US equity markets.
Trade flows measure the net exports and imports of a given country. These two components (exports and imports) constitute what economists call the current account.
Countries that have a positive current account (exports greater than imports) are more likely to depreciate their currency; this way the consumer abroad will perceive the foreign currency to be cheaper (and can purchase more goods and services). A good example is Japan.
On the other hand, countries that have a negative current account (imports greater than exports) are more likely to appreciate their currency since they need to sell the local currency and buy foreign currency in order to purchase goods and services. United States is an example of a net importer country.
Purchasing Power Parity (PPP)
This theory states that exchange rates are determined by the relative prices of a similar basket of goods in different countries. In other words, the ratio of prices of a basket with similar goods of two countries should be similar to the exchange rate.
If a Personal Computer in Australia costs AU$1,500, and the same PC in United States costs US$1,200. According to the PPP, the exchange rate AUD/USD would be 1.2500 (1,500/1,200).
If the exchange rate was at 1.3000 (or above 1.2500) it states that in the long run it will decrease its value until 1.2500 is reached. On the other hand, if the exchange rate was at 1.0500 (or below 1.2500) the exchange rate in the long run will increase its value until 1.2500 is reached.
This example is just illustrative, in the real world it is not just one good, but a basket of goods.
The major weakness of this theory is that it assumes that there are no costs related to the trade of goods (tariffs, taxes, etc). Another weakness is that it does not consider other factors that might influence the exchange rate (i.e. interest rates etc)
Modern monetary theories include the capital markets to the PPP theory arguing that capital markets have less costs of trading.
Interest Rate Theory
This theory states that interest rates differentials neutralize the increase or decrease of any currency against another currency. Therefore there are no arbitrage opportunities.
For instance if the interest rate of Australia is 6.25% and the interest rate of United States is 3.5%, then the AUD should depreciate against the USD, so that there are no arbitrage opportunities.
There are also other theories that try to explain the value of a currency pair. But as with every theory, they are based on assumptions that may or may not be present in the real world.