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.
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.