As most of you are aware, when the market for something is allowed to operate in an unrestricted manner, price is set by the intersection of supply and demand. This means that if there is more demand than supply for something then price should rise. Conversely if there is more supply than demand for something, then price should fall. When supply and demand are equal then price should stay the same.
Currencies are no exception to this basic economic concept. At its core the value for a free floating currency is determined by the demand for a particular currency in relation to its supply. While this is a simple concept, determining what the supply/demand situation for a particular currency is, and trying to forecast changes in that equation, is a little bit more difficult of a proposition, and is what currency traders who focus on fundamentals try to ascertain.
With this in mind ,whenever anything happens such as an increase or decrease in the amount of goods and services imported or exported by a country, an economic news release, speech by a fed official, or geopolitical event, a currency trader will always ask the question: “How does this affect the supply demand situation, and therefore the value of the currency that I am trading?”
In order to keep this straight in our heads its best to think of things that can affect the supply/demand equation as fitting into one of two categories. The first is what is known as trade flows. Trade flows are anything that involve money moving in and out of a country as a result of global commerce. This basically means money flowing out of countries as a result of goods and services being imported from other countries, and money flowing into countries as a result countries exporting goods and services to other countries.
When a country imports goods this adds currency of the importing country to the market and creates demand for the currency of the exporting country. The reason for this is that the goods are normally bought in the currency of the country where they are produced, so the entity importing the goods must exchange their currency for the currency of the entity that is exporting the goods.
As an example lets say that a US Corporation is importing 1 Million US Dollars worth of steel from a Canadian steel producer. In order to purchase this steel, the US Corporation must pay the Canadian corporation in Canadian dollars. As the US Corporation most likely does not have cash sitting around in Canadian Dollars, they will go out into the market and sell US Dollars and buy Canadian dollars.
As you can see here, the buying and selling of currencies which takes place as part of this transaction, creates an increase in demand for Canadian Dollars while simultaneously adding supply to the market for US Dollars. While a transaction of this size would not have much if any affect on the market, if this type of transaction was multiplied many times over, you could see how the two currencies of the countries involved in the transactions would be affected.
In general countries which rely heavily on imports will see a weakening affect on their currency as a result of this, all else being equal, and countries who have economies which are more export oriented will see a strengthening affect as a result, all else being equal.