What is an exchange rate?
The exchange rate is the price of one currency in terms of another. For example, if US$1 = €0.90, the exchange rate from dollars to euros is 0.90. Exchange rates matter because they influence the prices of imports and exports and, therefore, trade balances and inflation.
Exchange rate systems
- Floating exchange rate – determined by supply and demand in the foreign exchange market without direct government intervention.
- Fixed exchange rate – pegged to another currency or basket of currencies; the central bank intervenes to maintain the peg.
- Managed float – allows some market determination but with occasional central bank intervention to stabilise excessive movements.
Factors affecting exchange rates
- Trade balance – a current account surplus increases demand for a country’s currency; a deficit increases supply.
- Interest rates – higher domestic interest rates attract foreign capital, increasing demand for the currency and causing appreciation.
- Inflation – lower inflation relative to other countries makes exports more competitive, boosting demand for the currency.
- Speculation – traders’ expectations can move exchange rates if they anticipate future appreciation or depreciation.
- Political and economic stability – stable countries attract investors, strengthening the currency.
Consequences of appreciation and depreciation
| Appreciation | Depreciation | |
|---|---|---|
| Exports | Become more expensive abroad; may decrease in volume | Become cheaper abroad; may increase in volume |
| Imports | Become cheaper; domestic consumers benefit | Become more expensive; domestic consumers pay more |
| Inflation | Lower import prices help to contain inflation | Higher import prices can contribute to inflation |
| Economic growth | May slow down as net exports fall | Can stimulate growth via higher exports but may worsen inflation |
Exchange rate policy
Governments and central banks may intervene in foreign exchange markets through direct buying or selling of currencies, adjusting interest rates or using exchange controls to influence the exchange rate. However, maintaining an overvalued or undervalued currency can be costly and unsustainable in the long run.
Examples and applications
After the United Kingdom voted to leave the European Union in 2016, the British pound depreciated sharply against other currencies. The weaker pound made UK exports cheaper and boosted tourism but also increased the cost of imported goods, contributing to higher inflation.
Countries that peg their currency must intervene to maintain the exchange rate. For example, Saudi Arabia pegs the riyal to the US dollar. When oil revenues fall, the central bank may need to use foreign reserves to support the peg, affecting domestic monetary policy.
In 1997–98, several Southeast Asian currencies experienced rapid depreciation during the Asian financial crisis. Investors withdrew capital, causing exchange rates to collapse. Countries like Thailand and Indonesia had to raise interest rates and seek assistance from the International Monetary Fund to stabilise their currencies.
