Causes of Exchange Rate Movements

Why did the naira move from about ₦1,460 per dollar in October 2025 to about ₦1,335 a year later? Why do importers worry about the price of oil? Why does a rise in interest rates in the United States send emerging market currencies down?

The questions are different, but the answer has the same structure: an exchange rate is a price, and like any price it is set by supply and demand, and it moves when something changes the amount of the currency that people want to buy or sell.

This topic explains what stands behind the supply of and demand for a currency: trade in goods and services, flows of investment and savings, inflation, interest rates, growth, confidence and expectations, and the actions of governments and central banks.

It also sets out the exchange rate policies a country can follow (free float, managed float, fixed rate and currency board) and the history of the Nigerian regime, from a long period of managed rates to the unification of the windows in 2023 and the market-driven system of today, with a worked example of a shift in supply and demand and its effect on the rate.

The next topic covers purchasing power parity and interest rate parity, the two theories that connect exchange rates to inflation and to interest rates.

The syllabus asks candidates to explain spot rates and what causes them to move. Read foreign exchange risk: transaction, translation and economic first.

Supply and demand

The value of the naira against the dollar is determined by the supply of and demand for naira (equivalently, dollars) in the foreign exchange market.

• Demand for naira (supply of dollars) comes from foreign buyers of Nigerian goods and services (crude oil, other exports), from exporters who convert their foreign currency receipts, from foreign investors buying naira assets (government bonds, shares), from remittances sent home by Nigerians abroad and from foreign direct investment.
• Supply of naira (demand for dollars) comes from importers who must pay in foreign currency, from Nigerians and firms who invest or hold assets abroad, from foreign investors selling naira assets and taking their money out, and from the repayment of foreign debt.

A balance of trade deficit (imports exceeding exports) means that more naira is being supplied (to buy foreign currency for imports) than is demanded, which tends to weaken the currency. For a country that earns most of its foreign currency from crude oil, a fall in the oil price reduces the supply of dollars and puts the naira under pressure.

A worked example

Suppose that the monthly demand for dollars (in billions) falls as the naira price of a dollar (R) rises, and the supply rises: D = 1.00 − 0.002 × (R − 1,330) and S = 1.00 + 0.002 × (R − 1,330). They are equal at R = ₦1,330. At ₦1,300 demand is $1.06bn and supply $0.94bn (excess demand); at ₦1,360 demand is $0.94bn and supply $1.06bn (excess supply); only at ₦1,330 do they balance.

Now a surge in imports adds $0.12bn to the demand at every rate: D = 1.12 − 0.002 × (R − 1,330). The new balance is where 1.12 − 0.002x = 1.00 + 0.002x, with x = R − 1,330, so x = 30 and R = ₦1,360: the naira depreciates by ₦30 per dollar. If the central bank now sells $0.06bn a month into the market (supply rises by 0.06), the balance is where 1.12 − 0.002x = 1.06 + 0.002x, so x = 15 and R = ₦1,345: the intervention halves the depreciation.

It cannot, without large reserves, hold the rate indefinitely against a persistent excess demand.

Underlying causes of change

• Inflation differences: a country with higher inflation than its trading partners finds its goods dearer, so its exports fall and imports rise; in time its currency depreciates. This is the idea of purchasing power parity (next topic).
  Example: with inflation of 20% in Nigeria and 3% in the United States, prices in Nigeria rise 16.5% more than in the United States (1.20 ÷ 1.03); if the nominal rate did not move, Nigerian goods would become 16.5% dearer in dollar terms and exports would suffer, so there is pressure for a rate of about 1,335 × 1.20 ÷ 1.03 = ₦1,555.
• Interest rate differences: higher interest rates attract foreign capital seeking a return, raising the demand for the currency (the basis of interest rate parity, next topic). Nigeria’s high policy rate (23% from 22 September 2026) has supported inflows into government securities, but capital that comes for the interest can leave quickly.
• Economic growth and prospects: a strong economy attracts investment; a weak one repels it, though fast growth driven by imports can raise the deficit.
• Balance of payments and reserves: persistent deficits drain reserves and weaken confidence; a large reserve (Nigeria’s gross reserves rose to about $50bn in early 2026) allows a central bank to smooth the market.
• Political and economic stability and policy credibility: investors avoid uncertainty; changes in policy, security or fiscal position move the rate.
• Expectations and speculation: traders buy a currency they expect to rise and sell one they expect to fall; since exchange rates respond at once to news, the rate often moves before the event itself.
• Commodity prices and remittances: for Nigeria, oil prices and the money sent by Nigerians abroad are among the largest sources of foreign currency.

Exchange rate policies

• Free floating: the government has no policy for the rate; the market sets the value of the currency.
• Managed floating: the market sets the rate, within target limits; if the rate threatens to breach them, the central bank acts, buying or selling currency or changing interest rates.
• Fixed rate: the rate is fixed against another currency (such as the dollar) or a basket, with small variations allowed. The two economies must remain similar (especially inflation) or the pressure on the rate becomes too great, and the country is exposed to any crisis in the other economy.
• Currency board: a fixed rate backed by reserves, so that every new unit of domestic currency is supported by foreign currency. It gives stability but may constrain the money supply and push up interest rates; it has worked in Hong Kong but failed in Argentina.

The most effective means a government has of influencing the rate today is by interest rates, since large markets overwhelm intervention except in a few countries.

Nigeria’s regime

For many years the Central Bank of Nigeria managed the rate: through auction systems such as the Dutch Auction System (the wholesale auction introduced in 2006 and the retail auction from 2013), a fixed official rate and, at times, several separate windows with different rates, which produced a wide gap between the official and parallel rates (the premium rose above 60%) and a backlog of unpaid foreign currency obligations.

In June 2023 the Bank unified the windows and let the naira float, a “market-driven” rate set by willing buyers and sellers in the Nigerian Foreign Exchange Market; the Electronic Foreign Exchange Matching System, introduced in late 2024, automates the matching of orders to improve transparency.

The Bank still intervenes occasionally, and the large fall of the naira when the windows were unified and the later recovery show how sensitive the rate is to supply and demand, reserves and confidence. By late 2025 the gap between official and parallel rates had narrowed to a few per cent, and external reserves had been rebuilt.

The ideas in more depth

Why a fixed rate cannot be defended for ever

To hold a rate above its market level, a central bank must keep selling foreign currency out of its reserves; reserves are finite. Speculators who see this can bet on a devaluation, which adds to the pressure. When the reserves run low, the rate is changed, often by a large step, and the confidence that was spent in the defence is lost.

A country that wants a stable rate needs either large reserves, policies that keep its inflation close to that of its anchor currency, or both.

Why the exchange rate responds at once to news

Currency traders compare today’s rate with the value they expect after the news. A rise in the policy rate that was not expected strengthens the currency in minutes, because the new return is available immediately to anyone who moves funds.

In an efficient market (see the earlier topic) only news, not what was already expected, moves the rate, which is why forecasting exchange rates is so difficult and why companies hedge rather than predict.

Sources and references

• The Central Bank of Nigeria’s statements on its foreign exchange reforms (unification of windows in June 2023, the Electronic Foreign Exchange Matching System and the Foreign Exchange Manual); the Monetary Policy Committee communiqués (the Monetary Policy Rate was 23% from 22 September 2026).

These points are stated as at 5 November 2026.

Worked examples

1. Balance. 0.12 = 0.004x, so x = 30.
2. Rate.
   1,330 + 30 = ₦1,360; the naira depreciates by ₦30.

1. Balance. 0.06 = 0.004x, so x = 15.
2. Rate. ₦1,345.

1. Ratio.
   1.20 ÷ 1.03 = 1.165.
2. Gap. 16.5%.

How to answer in the exam

• Identify the sources of supply and demand in the case: trade, investment, remittances, oil.
• Link each factor to the direction of the rate and state whether the currency strengthens or weakens.
• Name the policy regime and what the authorities can and cannot do.
• Conclude on the likely direction and the reliability of the forecast.

Common mistakes in the exam

• Mixing up appreciation and depreciation in a direct quote.
• Saying that higher inflation strengthens a currency.
• Forgetting that higher interest rates attract capital only if the risk is acceptable.
• Describing the Nigerian regime as it was before 2023.
• Ignoring expectations and speculation.
• Saying that a central bank can hold any rate for ever.

Quick revision

• The rate is set by supply and demand: trade, investment, remittances, expectations.
• Higher inflation: weaker currency; higher interest rates: stronger currency.
• Regimes: free float, managed float, fixed, currency board.
• Nigeria: windows unified June 2023; market-driven now.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

Spotted a mistake? Tell us and we will check it.