A currency is the only product whose price affects the price of every other product a country buys or sells. When it moves, every import gets dearer or cheaper at once, every exporter's competitiveness changes, and nobody has decided any of it. The exchange rate is a price like any other, set by demand and supply, and the whole topic follows from asking who wants a currency and why.
Exchange rate
The price of one currency expressed in terms of another.
Demand for a currency comes from anyone who needs it. Foreigners buying the country's exports must obtain its currency to pay for them. Foreign investors buying its shares, bonds or property need it. Speculators buy it if they expect it to rise. Tourists visiting need it to spend. Supply of the currency comes from the mirror image: domestic residents buying imports must sell their own currency to obtain foreign currency, as must domestic investors buying foreign assets, speculators expecting a fall, and residents travelling abroad.
Appreciation and depreciation apply to floating rates, where the market moves the price. Revaluation and devaluation apply to fixed rates, where the government deliberately changes the pegged value. Using devaluation to describe a market fall is a persistent error and examiners notice it. If the rate floats, say depreciation.
Floating exchange rate
An exchange rate determined by the demand for and supply of the currency on the foreign exchange market, without government intervention to fix its value.
Foreign currency = domestic amount x exchange rate Domestic currency = foreign amount / exchange rateAlways write the rate with its units, as in $1 = £0.80, before calculating. Most errors in these questions come from multiplying when you should divide, and stating the units makes the right operation obvious.
What an appreciation does to importers and exporters
A currency appreciates from $1 = 4 pesos to $1 = 5 pesos. A domestic exporter sells a machine for 20,000 pesos. An importer buys components priced at $6,000. Calculate the effect on each, and state who gains.
The consequences run through the whole economy. A depreciation makes exports cheaper abroad and imports dearer at home, so export volumes tend to rise and import volumes to fall, which supports domestic output and employment. But dearer imports raise the cost of raw materials and components for domestic firms, and the price of imported consumer goods, so inflation tends to rise. An appreciation does the reverse: it restrains inflation by making imports cheaper but squeezes exporters and the industries competing against imports. Neither direction is straightforwardly good, which is why exchange rate policy is contested.
A country's currency depreciates. Which is the most likely immediate effect?
Which would increase demand for a country's currency on the foreign exchange market?
Draw a foreign exchange market diagram with the exchange rate on the vertical axis and quantity of the currency on the horizontal axis. Show demand and supply meeting at an equilibrium rate. Then show separately the effect of a rise in exports, and the effect of a rise in domestic interest rates attracting foreign investment.
Both shocks shift demand right and appreciate the currency, but for different reasons, and questions expect the reason rather than just the direction. Label the vertical axis with actual units, such as dollars per peso, because 'exchange rate' alone leaves it ambiguous which way an increase means the currency has moved.
Exchange rate systems
Under a floating exchange rate the value is set entirely by demand and supply, with no official intervention. The advantages follow from that freedom. The rate adjusts automatically towards correcting a trade imbalance, since a deficit means more currency supplied than demanded and the rate falls, making exports cheaper. No foreign currency reserves are needed to defend any particular level. And monetary policy is freed to pursue domestic objectives such as inflation and employment, rather than being committed to holding a rate. The disadvantage is volatility, since speculation can move the rate far from anything justified by trade, and uncertainty discourages long-term contracts and investment.
Under a fixed exchange rate the government commits to a particular value and maintains it. To prevent depreciation the central bank buys its own currency using foreign reserves, and raises interest rates to attract inflows; to prevent appreciation it sells its own currency, accumulating reserves. The advantages are certainty for traders and investors, and discipline, since a government cannot inflate its way out of trouble without losing the peg. The costs are severe. Large reserves must be held. Monetary policy becomes hostage to the exchange rate, so interest rates may have to rise in a recession. And an overvalued peg invites speculative attack, because speculators know reserves are finite while their selling need not be.
Most systems in practice lie between. A managed float lets the rate move but with the central bank intervening to smooth volatility or resist movements it judges excessive. A crawling peg fixes the rate but adjusts it in small planned steps, often to accommodate higher domestic inflation. Currency unions abolish exchange rates between members entirely, delivering maximum certainty at the cost of surrendering both monetary policy and the exchange rate as adjustment mechanisms, which is why an asymmetric shock inside a currency union has to be absorbed by wages, prices or migration instead.
Why a fixed rate constrains domestic policy
- A government pegs its currency and commits to defending the rate.
- The domestic economy enters recession, so the appropriate domestic policy is a cut in interest rates to stimulate demand.
- Lower interest rates make domestic assets less attractive to foreign investors, so capital flows out.
- Capital outflow means the currency is being sold, putting downward pressure on the pegged rate.
- To defend the peg the central bank must buy its own currency with foreign reserves, and raise interest rates to attract capital back.
- Raising interest rates is the opposite of what the recession requires, so output falls further and unemployment rises.
- The government must choose between the peg and the domestic economy, and if reserves run down before confidence returns, the choice is made for it and the peg breaks.
This is the impossible trinity in narrative form: a country cannot simultaneously have a fixed exchange rate, free capital movement and an independent monetary policy. It can have any two. Naming that trade-off explicitly is a reliable way into the higher bands.
Practise this chain →Several forces determine a floating rate and questions expect more than trade flows. Relative interest rates drive short-term capital movements and dominate day-to-day changes, since higher rates attract deposits. Relative inflation rates matter over the long run, because a country with persistently higher inflation loses competitiveness and its currency tends to fall, which is the purchasing power parity idea. Trade flows matter through the current account. Speculation can dominate everything in the short run, and is self-reinforcing since expectations of a fall cause selling which causes the fall. Government intervention and confidence in the economy and its institutions matter too.
A country with a fixed exchange rate faces persistent downward pressure on its currency. Which pair of actions would defend the peg?
Draw a foreign exchange market showing the equilibrium rate below a government's target fixed rate. Mark the excess supply of the currency at the fixed rate. Show how central bank purchases of its own currency shift demand right to hold the rate, and mark the reserves used.
The gap between quantity supplied and quantity demanded at the pegged rate is what the central bank must absorb every period, and it is the reason defence is finite. Reserves are a stock and the excess supply is a flow, so a persistently overvalued peg exhausts the stock eventually however large it is. That is the mechanism behind every currency crisis.
Applied context
The collapse of European fixed exchange rate arrangements in 1992 illustrates the impossible trinity in practice. Countries committed to holding their currencies within narrow bands found that domestic conditions calling for lower interest rates conflicted with the rates needed to defend the peg. Speculators, recognising that reserves were finite and the domestic political cost of high rates was rising, sold heavily against the weaker currencies. Several governments spent large fractions of their reserves and raised rates sharply before abandoning the commitment within days. Those that floated subsequently recovered faster than those that persisted with defence.
Use this to make the analytical point that a peg is only credible if markets believe the government will accept the domestic cost of defending it. Credibility, not reserves, is what actually holds a fixed rate.