Exchange Rate

The Concept of Relative Currency Prices

An exchange rate expresses the price of one currency in terms of another, establishing the rate at which they can be exchanged. When quoted as USD/EUR = 1.10, this indicates that one US dollar purchases 1.10 euros, or equivalently, one euro costs $0.91. These bilateral exchange rates form an interconnected web: if we know USD/EUR and EUR/JPY, we can calculate USD/JPY through triangular arbitrage. Any persistent deviation from this calculated rate would create risk-free profit opportunities that traders would immediately exploit, keeping exchange rates consistent across currency pairs.

The foreign exchange market where these rates are determined constitutes the largest financial market globally, with daily turnover exceeding $7 trillion. Unlike stock exchanges with defined trading hours and centralized locations, forex operates 24 hours a day, five days a week, following the sun from Sydney to Tokyo to London to New York. Major banks serve as market makers, quoting bid and ask prices for large volumes, while retail traders access the market through brokers offering high leverage. This continuous trading and enormous liquidity mean that exchange rates for major currencies can adjust instantly to news, creating volatility that dwarfs most other asset classes.

The economic significance of exchange rates extends far beyond currency traders' concerns. For exporters, a stronger domestic currency makes their products more expensive abroad, potentially costing market share and forcing difficult choices between accepting lower margins or losing sales. Importers face the opposite situation: currency strength reduces the domestic-currency cost of foreign inputs and finished goods. Tourists experience exchange rates directly through their purchasing power abroad—a strong home currency makes foreign vacations cheaper, while a weak currency makes them luxuries. Multinational corporations managing operations across dozens of countries must constantly hedge currency exposures to avoid earnings volatility purely from exchange rate movements.

Exchange Rate Regimes

Countries adopt different frameworks for determining their currencies' external values, ranging from pure floats where market forces reign supreme to rigid pegs maintained through central bank intervention.

Floating exchange rates, employed by most major developed economies, allow market supply and demand to set prices with minimal government interference. The US dollar, euro, Japanese yen, British pound, and Swiss franc all float freely, their values fluctuating daily based on capital flows, trade balances, interest rate differentials, and shifting perceptions of economic prospects. This flexibility provides automatic adjustment to shocks: if a country experiences a sudden decline in export competitiveness, its currency naturally depreciates, helping to restore balance by making exports cheaper and imports more expensive. The automatic stabilizer property of floating rates appeals to policymakers, who can focus monetary policy on domestic objectives without concerning themselves with maintaining a particular exchange rate.

Fixed or pegged exchange rates commit governments to maintaining a specific value against another currency (typically the dollar or euro) or a basket of currencies. Hong Kong, for instance, has pegged its dollar to the US dollar at approximately 7.8 HKD/USD since 1983, requiring the Hong Kong Monetary Authority to buy or sell HKD as needed to defend the peg. Saudi Arabia and other Gulf states similarly peg to the dollar, viewing exchange rate stability as crucial for oil trade and financial planning. These arrangements sacrifice monetary policy independence: interest rates must adjust to maintain the peg regardless of domestic economic conditions. During the Asian Financial Crisis of 1997-98, several countries discovered the peril of fixed rates when speculative attacks overwhelmed their foreign exchange reserves, forcing painful devaluations.

Managed floats represent a hybrid approach where currencies primarily float but central banks intervene to smooth excessive volatility or prevent misalignment. China employed this framework for years, allowing gradual yuan appreciation but resisting market pressures for rapid adjustment. Singapore operates an explicitly managed float targeting a trade-weighted exchange rate band rather than focusing solely on domestic inflation. The advantages of managed floating lie in combining some automatic adjustment with reduced short-term volatility, though the approach requires large foreign exchange reserves and risks credibility loss if the market perceives intervention as resisting fundamental pressures.

The choice of exchange rate regime involves fundamental trade-offs captured by the impossible trinity (or trilemma): a country cannot simultaneously maintain a fixed exchange rate, free capital flows, and independent monetary policy. It must sacrifice at least one. This constraint explains why the Bretton Woods system of fixed rates collapsed in the early 1970s as capital controls broke down, and why small open economies often find their policy options limited.

Fundamental Determinants of Exchange Rates

Exchange rate movements reflect a complex interaction of economic fundamentals, capital flows, and market psychology, with no single factor dominating at all times or across all currency pairs.

Interest rate differentials exert powerful influence through covered and uncovered interest parity relationships. When one country offers higher interest rates than another, capital flows toward the high-yield currency seeking better returns, appreciating it until the exchange rate has adjusted enough to offset the interest advantage. Under covered interest parity, any deviation from this relationship should disappear through arbitrage involving forward currency contracts. Uncovered interest parity, which requires only spot rate expectations rather than locked-in forwards, holds less reliably due to risk premiums and the peso problem (rare but large movements that average forecasts miss).

The carry trade exploits interest differentials by borrowing in low-rate currencies (historically the Japanese yen or Swiss franc) and investing in high-rate currencies (Australian dollar, Brazilian real, Turkish lira), earning the spread. This strategy works during stable periods but can unwind violently during risk-off episodes when investors flee emerging markets and the funding currencies appreciate sharply. The 2008 crisis witnessed a spectacular carry trade unwind as panicked investors closed positions, causing the yen to appreciate 20% in months despite Japanese rates remaining at zero.

Relative economic growth affects exchange rates through multiple channels. Faster growth attracts foreign capital seeking investment opportunities, increasing demand for the appreciating currency. Strong growth also tends to correlate with higher interest rates as central banks normalize policy or inflation pressures build, reinforcing the appreciation. However, growth differentials work through expectations and relative performance: if markets have already priced in strong growth, realization of that growth may not move the currency. Surprises matter more than levels.

Inflation differentials determine the evolution of real exchange rates over time through purchasing power parity (PPP). This theory posits that identical goods should cost the same in all countries when expressed in a common currency—the law of one price. If inflation runs higher in Country A than Country B, Country A's currency should depreciate to maintain constant relative prices. While PPP holds reasonably well over very long periods (decades), short and medium-run deviations can persist for years as capital flows, productivity differentials, and non-traded goods prices drive wedges between actual and PPP-implied exchange rates.

The current account balance—the broadest measure of a country's trade and income flows with the rest of the world—influences exchange rates through its effect on currency supply and demand. Countries running persistent current account surpluses (exporting more than importing) experience steady inflows of foreign currency from trade customers, creating appreciation pressure. Deficit countries face the opposite, though capital account surpluses (foreign investment inflows) can offset trade deficits, as the United States has demonstrated for decades. The relationship proves looser than simple trade balance accounting might suggest because capital flows often dominate trade flows in size and volatility.

Policy Implications and Currency Wars

Governments occasionally view their exchange rates as policy tools rather than purely market-determined outcomes, leading to intervention, capital controls, or verbal "jawboning" intended to influence currency values. The temptation stems from the competitive advantages of depreciation: cheaper currency boosts exports, supports domestic employment, and can inflate away foreign-currency-denominated debts. These beggar-thy-neighbor policies risk provoking retaliation, degenerating into currency wars where all countries simultaneously attempt to depreciate, leaving everyone worse off through reduced trade and increased volatility.

The Plaza Accord of 1985 demonstrated coordinated intervention's potential effectiveness. Facing complaints from US manufacturers hurt by the strong dollar, finance ministers and central bank governors from the G5 nations (US, Japan, Germany, France, UK) agreed to jointly intervene to weaken the dollar. The coordinated sales of dollars and purchases of yen and deutschmarks succeeded dramatically, with the dollar falling roughly 50% against these currencies over the subsequent two years. However, the subsequent Louvre Accord attempt to stabilize rates after their sharp fall proved less successful, illustrating the difficulty of fine-tuning market outcomes.

More recently, accusations of currency manipulation have centered on China's management of the yuan. Critics argue that China artificially undervalues its currency to gain export advantages, accumulating massive foreign exchange reserves (peaking above $4 trillion) through intervention. China counters that its managed float reflects legitimate development policy and points to gradual appreciation over the past two decades. The designation of currency manipulator carries both symbolic weight and potential trade policy consequences, though proving manipulation requires demonstrating both intent and specific harmful effects on trade partners—a high bar rarely cleared.

Conclusion

Exchange rates serve as relative prices that equilibrate international transactions, allocate capital across borders, and adjust to fundamental economic changes. Their determination reflects a complex interaction of interest rates, growth differentials, inflation, trade flows, and market expectations. The regime choice between floating and fixed rates involves trade-offs between adjustment flexibility and commitment credibility. Understanding exchange rate dynamics matters not only for international investors exposed to currency risk but for anyone seeking to comprehend how national economies connect through trade and capital flows in an integrated global financial system.

Further Reading

• IMF: Exchange Rate Regimes
• Federal Reserve: Foreign Exchange Data
• BIS: Triennial Forex Market Survey