The foreign exchange market

An exchange rate is the price showing how much of one currency must be exchanged for one unit of another. The foreign exchange market is where currencies are bought and sold.

There are two sides to every foreign-exchange transaction. When a household sells its domestic currency to obtain foreign currency, it increases the supply of the domestic currency and the demand for the foreign one. Ask yourself, “Which currency is actually being bought?” This usually keeps the arrows pointing the right way.

Exchange rates need precise quotations. Suppose one luna exchanges for 2.50 crowns. The rate is written as 2.50 crowns per luna. Luna, the currency being traded, goes on the horizontal axis; its price in crowns goes on the vertical axis. Labelling that axis simply as “price” isn’t enough.

A floating exchange rate system is an exchange-rate arrangement in which market demand and market supply determine the currency's value, with no target imposed by the government or central bank.

The demand curve for a currency slopes downwards. Other things equal, a lower price makes the country's exports and assets cheaper for foreigners. The supply curve slopes upwards because a higher price makes foreign goods and assets cheaper for domestic residents, so they’re encouraged to sell more domestic currency. Where the two curves intersect, they determine the equilibrium exchange rate and equilibrium quantity exchanged.

On the diagram, label the vertical axis as the price of the domestic currency in another currency—for example, “crowns per luna”. The horizontal axis should show the quantity of luna. A rightward shift in demand raises the equilibrium exchange rate, whereas a rightward shift in supply lowers it.

Appreciation and depreciation

An appreciation is an increase in a currency's market-determined value relative to another currency. A depreciation is a decrease in a currency's market-determined value relative to another currency. Use these terms when market forces change the exchange rate in a floating system. They may also describe market movements within a managed system.

If demand for luna rises from $D_1$ to $D_2$, its price in crowns rises, so the luna appreciates. If the supply of luna rises from $S_1$ to $S_2$, its price falls and the luna depreciates. Against the luna, the other currency necessarily moves in the opposite direction.

Currency conversion

If a product costs 80 luna and $E = 2.50$ crowns per luna, convert its price into crowns as follows:

Check the units to decide whether to multiply or divide. To convert 200 crowns back into luna, divide by 2.50 crowns per luna. When the quotation is given in the opposite direction, use the reciprocal: 2.50 crowns per luna is equivalent to 0.40 luna per crown.

Following the transaction

When demand or supply changes, the market equilibrium shifts. A reliable way to work through the effect is to follow the whole chain:

1. identify the international transaction;
2. work out which currency must be purchased;
3. decide whether demand for or supply of the domestic currency changes;
4. state the curve shift; and
5. conclude whether the domestic currency appreciates or depreciates.

Trade in goods and services

When foreign demand for a country’s exports increases, demand for its currency rises. Foreign buyers generally need that currency to pay the exporters. The demand curve shifts right, so the currency tends to appreciate.

Higher domestic demand for imports works in the opposite direction. Domestic buyers sell their own currency to obtain foreign currency. This increases the supply of the domestic currency and puts downward pressure on its value.

Investment flows

Foreign direct investment is an international investment flow through which an investor acquires a lasting interest and significant influence in an enterprise located in another economy. With inward direct investment, foreigners generally need to buy the recipient country’s currency, raising demand for it. Outward direct investment generally increases the supply of the investor’s domestic currency.

Portfolio investment is an international investment flow involving financial assets such as shares and bonds without significant control over the issuing enterprise. Inward purchases of domestic securities raise demand for the currency. Outward purchases of foreign securities increase its supply.

Some of these effects may be partly reversed later. For instance, sending profits back to an overseas owner may require the domestic currency to be sold. What matters is the direction and timing of the actual currency transaction—not simply the label “investment”.

Remittances and speculation

A remittance is a transfer of income by a person working in one economy to a recipient in another economy. When transferred funds are converted, an inward remittance normally raises demand for the recipient country’s currency. An outward remittance normally increases the supply of the sender’s currency.

Currency speculation is the purchase or sale of a currency in anticipation of profiting from a future exchange-rate change. Traders who expect appreciation may buy the currency now. Demand then shifts right, possibly bringing the expected appreciation forward. Expected depreciation may trigger selling and increase supply. Expectations can reinforce themselves, though they may also turn out to be wrong.

Relative inflation, interest and growth rates

Currencies are always compared with one another, so relative values matter.

• If domestic inflation is higher than inflation abroad, domestic products become relatively expensive. Foreign demand for exports may decrease while domestic demand for imports rises. Demand for the domestic currency falls, supply increases and depreciation becomes more likely.
• If domestic interest rates rise relative to foreign rates, domestic deposits and bonds may provide a higher return. Inward portfolio investment can increase demand for the currency and cause appreciation. However, this depends on expectations about inflation, risk and future exchange-rate movements; a high nominal interest rate isn’t automatically attractive.
• Faster domestic economic growth raises incomes and may lead to more imports, adding to the currency’s supply. At the same time, strong growth can attract inward investment and raise demand. The net exchange-rate effect is therefore ambiguous and depends on which change is larger.

Central bank intervention

Central bank intervention is the purchase or sale of currencies by a monetary authority in order to influence an exchange rate. When the central bank buys the domestic currency using foreign-currency reserves, demand increases and supports its value. Selling the domestic currency to buy foreign currency raises its supply and restrains appreciation. Such intervention is central to fixed and managed systems, although authorities may occasionally intervene in an otherwise floating market.

Calculating a change in value

For a directly quoted exchange rate, the percentage change is:

where $\%\Delta E$ is the percentage change in the exchange rate (%), $E_0$ is the initial exchange rate in units of the price currency per unit of the base currency, and $E_1$ is the new exchange rate in the same units.

Suppose the price of one luna increases from 0.80 crowns to 0.92 crowns:

The luna has appreciated by 15% against the crown. If the quotation drops from 0.92 back to 0.80, the depreciation is approximately 13.0%, not 15%, because the second calculation uses a different initial value. Check the quotation before interpreting the sign as well: an increase in crowns per luna means luna appreciation, whereas an increase in luna per crown means crown appreciation.

The transmission mechanism

Exchange-rate changes mainly affect the economy through export and import prices. A depreciation makes exports cheaper for foreign buyers but raises the price of imports for domestic buyers. An appreciation reverses these effects. The resulting price changes influence aggregate demand, production costs and household purchasing power.

The process isn’t automatic. The final outcome depends on price elasticities of demand and the amount of spare capacity in the economy. Reliance on imported inputs, business confidence and how quickly buyers can switch suppliers also matter.

Inflation, growth and unemployment through aggregate demand

Aggregate demand is the total planned spending on domestically produced final goods and services at each average price level during a period. It includes net exports, written as $X-M$, where $X$ is spending on exports measured in domestic currency per period and $M$ is spending on imports measured in domestic currency per period.

Suppose depreciation raises export revenue while reducing import expenditure. Net exports increase, so aggregate demand shifts right. Real output may rise and demand-pull inflation may occur. Firms expand production, which can reduce cyclical unemployment. Appreciation can have the opposite effect: lower net exports, a leftward shift in aggregate demand, weaker growth and higher cyclical unemployment.

Spare capacity determines how large the output effect will be. If substantial unused resources exist, a rightward shift of aggregate demand may cause a relatively large increase in real output. Near productive capacity, that same shift is more likely to generate inflation.

Inflation through production costs

Depreciation raises the domestic-currency price of imported raw materials, components and energy. Firms then face higher production costs, shifting short-run aggregate supply to the left. This can create cost-push inflation alongside lower real output. A weaker currency can therefore raise inflation even when aggregate demand is weak.

By making imported inputs cheaper, an appreciation can shift short-run aggregate supply right and ease cost pressures. This effect will be stronger when an economy depends heavily on imported fuel, machinery or intermediate goods.

The sharp depreciation of the Japanese yen during 2022 provides a useful real-world example. Japan imports much of its energy, so the weaker yen increased the domestic cost of fuel and other imported inputs. This contributed to inflation even though domestic demand was not exceptionally strong.

The current account balance

The current account balance is the difference between current-account credits and debits arising from trade in goods and services, primary income and secondary income. Depreciation may improve the balance because exports become more price competitive while imports become less attractive. Appreciation may worsen it by making exports dearer and imports cheaper.

Still, do not jump straight from “depreciation” to “current-account improvement.” Contracts remain fixed in the short run, and consumers may have few substitutes for essential imports. Import expenditure can initially increase because every imported unit costs more. Over time, the balance is more likely to improve if export and import quantities respond strongly enough to the price changes.

Living standards and stakeholder effects

A living standard is a level of material well-being reflected in people's access to goods and services and their real purchasing power. Appreciation makes imports and foreign travel cheaper, increasing the purchasing power of domestic income. It also lowers the domestic-currency cost of servicing debts denominated in foreign currency.

Exporters and firms that compete with imports, however, may lose sales after an appreciation. Employment and income may then be threatened. Depreciation benefits some exporters and import-competing firms, but households must pay more for imported consumption goods and may also face higher inflation. Borrowers with foreign-currency debt face larger repayments in domestic currency as well.

The same exchange-rate change creates winners and losers. Its effect on average living standards depends on employment, real income, consumer choice and the economy's exposure to imported necessities—not just on whether imports become cheaper or dearer.

The peg

A fixed exchange rate system is an exchange-rate arrangement where a central bank commits to keeping its currency at an officially chosen value against another currency or reference asset. This chosen value is the peg: an official exchange-rate target defended through policy intervention.

Demand and supply still change under a fixed system, so the foreign-exchange market continues to operate. The central bank instead offsets any pressure that would push the exchange rate away from the peg.

Devaluation and revaluation

A devaluation is an official reduction in the value of a currency's peg by the government or central bank. An official increase in the peg is a revaluation. Both are policy decisions made within a fixed system. Depreciation and appreciation, by contrast, result from market movements. The wording differs only slightly, but the economic distinction matters.

Following a devaluation, exports become cheaper for foreign buyers while imports become more expensive for domestic buyers. The consequences are similar to those of a depreciation. A revaluation produces consequences similar to an appreciation.

Maintaining a fixed rate

Suppose demand for the domestic currency falls, creating excess supply at the official rate. The central bank prevents depreciation by buying the excess domestic currency and paying for it with foreign-currency reserves. Demand shifts right, keeping the market price at the peg.

When upward pressure develops, the central bank sells domestic currency and buys foreign currency. This extra supply prevents appreciation and increases foreign reserves.

Interest-rate policy can support this intervention. Higher domestic interest rates may attract inward financial flows, which increase demand for the currency and help maintain the peg. Lower rates may ease excessive upward pressure. The trade-off is that monetary policy may have to serve the exchange-rate target instead of domestic goals such as growth, employment or price stability.

A central bank can defend against downward pressure only while it has sufficient foreign-currency reserves or access to borrowing. Governments may also impose exchange controls—legal restrictions on purchases or sales of foreign currency—although these can create shortages, parallel markets and administrative costs.

Management within limits

A managed exchange rate system allows market demand and supply to move the currency, while the central bank intervenes to influence its level or prevent excessive fluctuations. It sits between a pure float and a rigid peg.

The authority might announce a permitted band, though it can operate without publishing an exact target. As the currency approaches the lower limit, the central bank can buy domestic currency, raise interest rates or use both measures. Near the upper limit, it can sell domestic currency or lower interest rates.

The diagram shows the market-determined equilibrium shifting after a change in demand. Intervention then prevents the exchange rate from moving outside the permitted band.

Overvalued and undervalued currencies

An overvalued currency is maintained above the exchange rate that unrestricted market demand and supply would determine. When the exchange rate is quoted as foreign currency per unit of domestic currency, the official or managed value is above the free-market equilibrium. Exports become relatively expensive and imports relatively cheap. This tends to weaken the current account and creates excess supply of the domestic currency.

Maintaining an overvalued rate may require the central bank to buy domestic currency with foreign reserves. It can also raise interest rates or restrict access to foreign currency. If overvaluation persists, it can drain reserves and suppress domestic activity.

An undervalued currency is maintained below the exchange rate that unrestricted market demand and supply would determine. Exports become relatively cheap, while imports become relatively expensive. This may support export revenue, aggregate demand and employment. Because there is excess demand for the domestic currency at that rate, the central bank can sell domestic currency and accumulate foreign reserves.

Undervaluation brings costs as well as benefits. Imported consumer goods and inputs become dearer, inflationary pressure may rise, and trading partners may object that the policy gives an artificial competitive advantage. Whether a managed value is desirable depends on the policy objective and the costs of intervention.

The case for floating

Under a floating system, the exchange rate works as an adjustment mechanism. A current-account deficit leads to sales of the domestic currency, encouraging depreciation. Exports become cheaper and imports dearer, which may help reduce the deficit. With a surplus, appreciation can produce the reverse adjustment. This correction may be slow or incomplete, but the authorities do not have to defend a particular rate.

The interest rate isn’t tied to maintaining a peg, so monetary policy can target domestic inflation, unemployment and growth more directly. The central bank also needs fewer large foreign-currency reserves.

That flexibility brings uncertainty. Exchange-rate volatility makes export receipts and import costs harder to predict, as well as returns on foreign investment and foreign-currency debts. A sudden depreciation can cause imported inflation. Speculative trading may also magnify short-run movements. Firms can hedge against currency risk, though hedging costs money and is less accessible to smaller businesses.

The case for fixed

A credible fixed rate cuts exchange-rate uncertainty and helps firms plan trade and investment. It can also act as an anti-inflation anchor. If excessive domestic inflation threatens the peg, governments and central banks come under pressure to maintain disciplined fiscal and monetary policies. Firms can’t depend on repeated depreciation to regain competitiveness, which may encourage them to improve productivity.

A deliberately undervalued peg can support exports, employment and growth. The trade-off is more expensive imports, possible inflation and tension with trading partners.

The main drawback is the loss of policy flexibility. Even when growth is weak and unemployment is high, interest rates may have to rise to defend the currency. The peg also requires reserves. If market pressure persists, devaluation may eventually become unavoidable. A sudden devaluation can weaken policy credibility and raise the domestic burden of foreign-currency debt.

Fixed rates may preserve the wrong price too. An overvalued peg harms export competitiveness and drains reserves, while an undervalued peg distorts consumption and trade. If speculators think the central bank lacks either the reserves or the political willingness to defend the peg, they may attack it.

Reaching a judgement

Neither system is always better. The country’s circumstances should shape the judgement:

• A small economy that depends heavily on trade may value stability against the currency of its main trading partner.
• An economy with a history of high inflation may use a credible peg as a policy anchor, provided fiscal policy supports it.
• An economy facing frequent external shocks may need a floating rate to absorb them.
• A country that requires an independent interest-rate policy is more likely to favour floating.
• Limited reserves, weak credibility or large mobile capital flows can make a fixed rate hard to maintain.
• When a country relies heavily on imported essentials, the inflationary risk from depreciation becomes especially serious.

Canada shows the flexibility argument in practice. Its floating currency can react to commodity-price and global financial shocks, while monetary policy stays focused on domestic inflation. Hong Kong demonstrates the stability argument: its linked exchange-rate arrangement supports confidence in a highly open financial centre, though domestic interest rates must closely follow the conditions required to preserve the link.

A managed system may provide a compromise by permitting some movement while limiting extreme volatility. It cannot remove the underlying trade-off. The more tightly authorities control the exchange rate, the more reserves and policy independence they may have to sacrifice.