International Economics

Exchange Rate

Price of one currency in another — affects trade, capital flows

Exchange rate is the price of one currency in terms of another (e.g., 1 USD = 0.85 EUR). Determined by: supply and demand in foreign exchange (forex) market. Influences: international trade, capital flows, tourism, inflation. Two regimes. (1) Fixed/pegged: government maintains specific rate (e.g., Hong Kong dollar to USD). (2) Floating: market-determined (most major currencies). Mixed: managed float. Appreciation: currency value rises; imports cheaper, exports more expensive. Depreciation: opposite. Major macro variable. Forex: largest financial market ($7+ trillion daily).

  • DefinitionPrice of one currency in another
  • Daily forex volume$7+ trillion
  • TypesFixed, floating, managed
  • DeterminantsTrade, capital flows, interest rates, inflation
  • AppreciationCurrency rises; imports cheaper, exports dearer
  • DepreciationOpposite

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Why exchange rates matter

  • International trade. Affect import/export prices.
  • Capital flows. Determine cross-border investments.
  • Tourism. Travel costs.
  • Multinational businesses. Costs and revenues across currencies.
  • Inflation. Imported goods affect prices.
  • Monetary policy. Affected by exchange rate.
  • International economics. Foundation.

Common misconceptions

  • Strong currency always good. Trade-offs.
  • Fixed = stable. Vulnerable to attacks.
  • Government can set whatever. Limited; markets resist.
  • Same as currency value. Relative; reciprocal of pair.
  • Stable in long run. Constant adjustment.
  • One way of measuring. Real, nominal, effective rates.

Frequently asked questions

What's an exchange rate?

Price of one currency in another. EUR/USD = 1.10 means 1 euro = 1.10 dollars. Or: USD/EUR = 0.91 means 1 dollar = 0.91 euros (reciprocal). Direction depends on convention. Shows: relative purchasing power across currencies. Determined by: supply and demand for currencies in forex market.

What determines exchange rates?

Multiple factors. (1) Trade balance: exporting country's currency demanded; appreciates. (2) Capital flows: investors moving capital affect demand. (3) Interest rate differentials: higher rates attract investors. (4) Inflation: high inflation tends to depreciate currency (purchasing power parity). (5) Expectations: about future rates. (6) Government intervention. (7) Speculation. Complex interactions.

What's a floating exchange rate?

Market-determined. Government doesn't intervene to maintain specific rate. Most major currencies floating: USD, EUR, JPY, GBP, etc. Advantages: market-clearing; absorbs shocks. Disadvantages: volatility; uncertainty for businesses. "Dirty float": occasionally interventions to manage. Most modern: managed floats with rare intervention.

What's a fixed exchange rate?

Government maintains specific rate. Used historically (Bretton Woods 1944-1971), some current cases (Hong Kong, Saudi Arabia). Mechanisms. (1) Currency board: 100% reserve backing. (2) Active intervention by central bank. (3) Legal restrictions. Advantages: stability for trade. Disadvantages: requires reserves; vulnerable to attacks; loss of monetary independence.

What's purchasing power parity?

Theory: in long run, currencies adjust so similar goods cost same across countries. Exchange rate equates purchasing power. Implication. Country with higher inflation: currency depreciates. Famous example: Big Mac index (Economist) — compares Big Mac prices to assess fair exchange rates. Reality: often deviations; PPP holds approximately long-run.

How do trade and exchange rates interact?

Trade deficit (imports > exports): more demand for foreign currency than domestic. Domestic currency depreciates. Makes exports cheaper, imports more expensive. Auto-correcting tendency: deficit reduced. Trade surplus: opposite. Real exchange rate (adjusted for inflation): more relevant for trade competitiveness than nominal.

What about currency wars?

Countries deliberately depreciating to gain trade advantage. Used in trade tensions. Methods: monetary easing, central bank intervention, capital controls. Not zero-sum globally — others retaliate. 1930s competitive devaluations made Great Depression worse. Modern: less common but accusations occur. China-US tensions: currency a recurring issue.