We’re all aware of how currencies move up and down relative to each other. Just ask any holidaymaker how a difference in the exchange rate makes them feel richer or poorer when they travel abroad. For example, if the pound rises in value against the American dollar, anyone on a shopping spree in New York can buy more with their pounds.

A market-based exchange rate will change whenever the value of currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply. This does not mean people no longer want money; it just means they prefer holding their wealth in some other form, possibly another currency. Increased demand for a currency is due to either an increased ‘transaction demand’ for money, or an increased ‘speculative demand’ for money.

The transaction demand for money is related to the country’s level of business activity, gross domestic product and employment levels. The more people there are out of work, the less the public as a whole will spend on goods and services.

Central banks, such as the Bank of England or the USA’s Federal Reserve, typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

The speculative demand for money is much harder for a central bank to accommodate, but it will try to do this by adjusting interest rates. Investors will choose to buy a currency if the return (that is, the interest rate) is high enough. The higher a country's interest rates, the greater the demand for that currency.

It has been argued that currency speculation can undermine real economic growth; in particular since large currency speculators may deliberately create downward pressure on a currency in order to force that central bank to sell its currency to keep it stable.

In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. Most people will not be interested in a currency if they think it will devalue. A currency will tend to lose value, relative to other currencies, if the country's level of inflation is relatively higher, if the country's level of output is expected to decline, or if a country is troubled by political uncertainty.

The most famous example in British history was Black Wednesday - when the pound fell out of the European Exchange Rate Mechanism (ERM) on 16 September 1992, after speculation led to downward pressure on the pound. The ERM was a system by which the value of the pound relative to other European Union currencies was not supposed to fluctuate by more than 6%.

To keep the value of the pound within this level, the then Chancellor, Norman Lamont (who had control of the Bank of England), raised interest rates from 10% to 15% in one day and spent billions buying pounds to try to fight off the speculators. But by the end of the day, the Government had to admit defeat in the face of the speculators, and the pound fell in value and out of the ERM.

Some analysts believe that the housing market crash of the early 1990s and the Conservative Government’s reputation for fiscal prudence were direct consequences of ERM crisis.

That the current Chancellor, Gordon Brown, subsequently made the Bank of England independent and free to set its own interest rates, is also a consequence of Black Wednesday.