4.5.1—Floating exchange rates

A currency appreciates when demand for it rises relative to supply, and depreciates when the balance moves the other way. Demand can come from exports, tourism and capital inflows; supply can come from imports and capital outflows.

The exchange rate is therefore a price. A depreciation makes imports more expensive in domestic currency and can make exports more competitive, but the size and timing of the response depend on elasticities and contracts.

On the currency market diagram, put the exchange rate (price of the domestic currency in the stated foreign currency) vertically and quantity of domestic currency horizontally; downward-sloping demand and upward-sloping supply determine equilibrium. A rightward demand shift appreciates the currency, while a rightward supply shift depreciates it. For conversion, follow the quotation: if £1=$1.25, a £80 good costs$100; a $100 good costs £80 by dividing by 1.25. Always label which currency is the unit to avoid multiplying when division is required.