4.5 Exchange Rates

An exchange rate is the price of one currency expressed in terms of another currency. Because currencies are traded against each other in the foreign exchange (forex) market, every exchange rate is a relative price: it tells you how many units of one currency ($X$) you must give up to obtain one unit of another currency ($Y$).

For example, if the exchange rate between the US dollar (USD) and the euro (EUR) is EUR 0.92 = USD 1, this means one US dollar can be exchanged for 0.92 euros. Exchange rates are quoted constantly by banks, currency traders, and financial markets, and they change from moment to moment as the demand for and supply of each currency shifts.

The exchange rate matters because it is the tool used to convert values between currencies. Any time a good, service, asset, or debt is priced in a foreign currency, the exchange rate determines its equivalent value in the domestic currency. This conversion function underpins international trade (pricing exports and imports), international investment (calculating returns on foreign assets), tourism, and the repayment of foreign-currency-denominated debt.

Exchange rates can be determined in different ways -- fixed (pegged) by government intervention, floating freely according to market supply and demand, or managed through a hybrid float -- but regardless of the system used to determine it, the exchange rate itself is always defined the same way: as the price of one currency in terms of another.

In a floating exchange rate system, a currency's value is determined by supply and demand in the foreign exchange market, just like any other good. But a currency is not wanted for its own sake -- it is wanted because of what it allows the holder to do. Demand for a currency is therefore a derived demand: it originates from foreigners' desire to buy a country's exports, to invest in its assets, or to hold the currency itself in anticipation of future gains.

There are three main sources of demand for a currency (using the euro, EUR, as the example currency demanded by foreigners):

• Demand for exports: When foreign buyers purchase goods and services produced in the eurozone, they must first acquire euros to pay eurozone producers in their own currency. A US importer buying German machinery must sell dollars and buy euros on the foreign exchange market. The larger the demand for a country's exports, the greater the demand for its currency.
• Capital inflows (investment): Foreign investors who want to buy eurozone assets -- shares, bonds, property, or a factory -- need euros to complete the purchase. This includes portfolio investment (financial assets) and foreign direct investment (physical assets/businesses). Higher interest rates or strong expected returns in the eurozone increase these capital inflows and therefore demand for euros.
• Holding the currency itself: Some demand comes from speculators or savers who want to hold euros because they expect the currency to appreciate, or because they view it as a stable store of value (a 'safe haven'). This demand is not tied to buying a specific export or asset transaction at that moment -- it reflects expectations about the currency's future value.

On a standard demand-and-supply diagram for the foreign exchange market, the demand curve for a currency (e.g. EUR, measured against USD on the vertical axis and quantity of EUR on the horizontal axis) slopes downward. As the price of EUR falls (i.e. it takes fewer USD to buy one EUR), eurozone exports become cheaper for US buyers, so a larger quantity of euros is demanded to pay for the extra exports purchased. Any of the three sources of demand above can shift this curve: a rise in foreign demand for eurozone exports, an increase in capital inflows seeking eurozone assets, or a surge in speculative buying will all shift the demand curve for euros to the right, raising the equilibrium exchange rate (an appreciation) if supply is unchanged.

It is useful to distinguish the stock of capital inflows a country might attract from the flow of transactions occurring at any moment. A one-off large foreign direct investment (e.g. a multinational building a new factory) creates a surge in demand for the local currency to fund that specific purchase, while ongoing portfolio investment (e.g. foreign funds continuously buying government bonds because of comparatively higher domestic interest rates) creates a more sustained rightward shift in currency demand. Both are examples of capital inflows increasing demand for a currency, distinct from export-driven demand.