4.5 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.

Currency demand rises when foreigners need the currency to buy exports, invest or visit. Currency supply rises when domestic residents buy imports, invest abroad or travel. Interest rates, income, inflation expectations and confidence can shift either curve.

For example, higher domestic interest rates may attract capital inflows and increase demand for the currency, but the effect depends on expected risk and future exchange-rate changes. Name the transaction before predicting a shift.

Use the full transaction map. Foreign demand for exports, inward FDI or portfolio investment and some inward remittances raise demand for the domestic currency; domestic import purchases, outward investment and outward remittances raise its supply. Speculation, relative inflation, relative interest rates, relative growth and central-bank intervention can shift either curve through expected returns and transactions. Calculate percentage appreciation or depreciation as $(\text{new rate}-\text{old rate})/\text{old rate}\times100$ only after fixing the quotation; the reciprocal quotation moves in the opposite direction by a different percentage.

A depreciation raises the domestic price of imports and lowers the foreign-currency price of exports, while an appreciation does the reverse. The effects on the trade balance depend on demand elasticities, domestic capacity and the time allowed for contracts to change.

A cheaper currency can initially worsen the trade balance if import payments rise before quantities respond—the J-curve idea. It can also add cost-push inflation through imported fuel and materials. Do not infer a guaranteed improvement from “more competitive exports.”

A depreciation can shift AD right through higher net exports, raising growth and lowering cyclical unemployment when spare capacity exists, but it can raise demand-pull and imported cost-push inflation. The current account improves only if export and import quantities respond sufficiently and after contract lags; imported goods and foreign travel become less affordable, lowering some living standards. Appreciation reverses these pressures: cheaper imports may lower inflation and improve purchasing power but weaker net exports can reduce growth and employment. Use AD/AS to show the initial context rather than claiming a fixed outcome.

Under a fixed exchange rate the central bank announces a target and buys or sells foreign currency to keep the market rate near it. To defend a weak currency it may sell reserves or raise interest rates; to resist appreciation it may buy foreign currency.

A peg can reduce uncertainty for traders, but reserves are finite and the policy may conflict with domestic objectives. If the target is inconsistent with fundamentals, speculation can force a devaluation or abandonment.

Devaluation is an official reduction of a fixed target; revaluation is an official increase, unlike market depreciation/appreciation. In the diagram, if the target lies above market equilibrium, excess currency supply puts downward pressure on the rate, so the central bank buys domestic currency using foreign reserves (and may raise interest rates). If the target lies below equilibrium, excess demand puts upward pressure on it, so the bank sells domestic currency and accumulates reserves. Label the target line, shortage or surplus and intervention direction.

A managed exchange rate normally moves with demand and supply, but the central bank intervenes to smooth volatility or influence a preferred range. It can use reserves, interest rates or communication, depending on the policy objective.

Management may reduce abrupt shocks without committing to a permanent peg, yet intervention can be costly and difficult to time. Always state whether the bank is defending a level, smoothing a movement or pursuing another goal.

An overvalued managed currency is held above its market-clearing value, producing excess supply and downward pressure; an undervalued currency is held below equilibrium, producing excess demand and upward pressure. Show the managed target or band against the demand-supply equilibrium, then identify purchases or sales of domestic currency, reserve changes or interest-rate action. Overvaluation can make imports cheaper but exports less competitive; undervaluation can support net exports but raise import prices and foreign-policy tensions.

A fixed rate offers predictability and can discipline inflation, but it requires reserves and sacrifices independent monetary policy. A floating rate preserves adjustment through the exchange rate and monetary autonomy, but creates uncertainty and may overshoot.

The better choice depends on trade exposure, financial credibility, shock type, reserve capacity and labour or fiscal flexibility. A small open economy with a highly mobile financial sector faces a different trade-off from a large diversified economy; there is no universal winner.