6.2 Exchange Rates

Foreign Exchange Market

The foreign exchange (forex) market is where currencies are bought and sold, determining the exchange rate — the price of one currency in terms of another. Under a flexible (floating) exchange rate system, rates are set by supply and demand for currencies, not fixed by governments.

Supply and Demand for Currency

The demand for a currency comes from foreigners wanting to buy that country's exports, invest in its assets, or travel there. The supply of a currency comes from domestic residents wanting to buy foreign goods, invest abroad, or travel. When demand for a currency rises, it appreciates; when supply rises (or demand falls), it depreciates.

Factors That Shift Currency Value

Changes in relative interest rates, income levels, inflation rates, and preferences for goods/assets shift currency supply/demand curves. Higher relative interest rates attract foreign investment, increasing demand and causing appreciation. Higher relative inflation makes goods less competitive, decreasing demand and causing depreciation.

Key terms

Exchange rate

The price of one currency expressed in terms of another currency.

Currency appreciation

An increase in the value of a currency relative to another currency.

Currency depreciation

A decrease in the value of a currency relative to another currency.

What increases demand for a currency?

Foreign demand for that country's exports, assets, or travel/tourism.

Effect of higher relative inflation on currency

Depreciation — goods become less competitive, reducing foreign demand for the currency.

Try an AP-style question

How many dollars does 1 euro cost?

1. $0.90
2. $0.11
3. $1.90
4. About $1.11