Exchange Rates and Currency Systems

An exchange rate is the price of one currency compared to another. It’s shaped by supply and demand, especially for floating currencies. Demand comes from foreigners buying exports, investing in assets, or betting on the currency’s rise.

In a floating system, rates move freely. A drop is depreciation, while a rise is appreciation. In a fixed system, the central bank sets a rate and defends it by buying or selling reserves. Here, we use devaluation and revaluation, since these are deliberate actions, not market-driven. Mixing up these terms is a common exam mistake.

What drives a floating rate? Relative interest rates, inflation rates, trade flows, speculation, and confidence matter. In the short term, interest rates and speculation take the lead. Over the years, trade and inflation become more important.

Depreciation makes exports cheaper abroad. It also makes imports more expensive at home. You’d think that’s a good thing, right? But there are complications. First, pricier imports can push domestic inflation up, especially for countries that rely on energy and food imports. Second, consider the Marshall-Lerner condition: the trade balance only improves if the combined demand elasticity for exports and imports is over 1. Typically, in the short run, it’s not. So, the trade balance often worsens before it gets better. That’s the J-curve.