Exchange rates

The price of one currency expressed in terms of another currency. For example, 1 USD = 0.85 EUR means one US dollar can be exchanged for 0.85 euros.

Automatic adjustment: if a country has a current account deficit, its currency depreciates, making exports cheaper and imports dearer, which helps correct the imbalance without government intervention.

Demand comes from: foreigners buying the country's exports, tourists visiting, foreign investors buying domestic assets (FDI, shares), speculators expecting the currency to appreciate, and interest rate differentials.

Supply comes from: domestic residents buying imports, tourists going abroad, domestic investors buying foreign assets, speculators selling the currency, and capital outflows seeking higher returns elsewhere.

Appreciation: the currency increases in value relative to another (can buy more foreign currency). Depreciation: the currency decreases in value relative to another (buys less foreign currency).

The central bank can set interest rates to meet domestic objectives (inflation, growth) without worrying about maintaining a specific exchange rate. This is not possible under a fixed system.

Higher interest rates attract foreign capital seeking better returns (hot money inflows). This increases demand for the domestic currency, causing it to appreciate. Lower rates have the opposite effect.

A system where the exchange rate is determined by the forces of supply and demand in the foreign exchange market, with no government intervention. The rate fluctuates continuously.

Volatility and uncertainty. Frequent fluctuations make it difficult for businesses to plan, price exports, and manage costs. This uncertainty can discourage international trade and investment.

The nominal exchange rate is the rate at which currencies are traded. The real exchange rate adjusts for differences in price levels between countries, showing the true purchasing power of a currency abroad.

Since the central bank does not intervene to fix the rate, it does not need to hold large reserves of foreign currency. Under a fixed system, reserves must be available to buy/sell currency to maintain the peg.

Higher inflation makes exports more expensive and imports relatively cheaper. Demand for the currency falls (fewer exports sold) while supply increases (more imports bought), causing the currency to depreciate.

If speculators expect a currency to appreciate, they buy it now (increasing demand), which actually causes appreciation — a self-fulfilling prophecy. Speculation can amplify exchange rate movements and create volatility.

A global, decentralised market where currencies are traded 24 hours a day. It is the world's largest financial market (over $6 trillion daily turnover). Exchange rates are determined here through supply and demand.

A depreciating currency raises import prices, contributing to cost-push inflation. If a country is dependent on imported raw materials, energy, or consumer goods, depreciation makes them all more expensive domestically.

A system where the government or central bank sets the exchange rate at a specific value against another currency (or basket of currencies) and intervenes in the forex market to maintain that rate.

Fixed: provides certainty for trade/investment but may require sudden devaluations. Floating: continuous small adjustments but creates uncertainty. Managed float tries to balance both.

A system where the exchange rate mostly floats freely but the central bank occasionally intervenes to smooth out excessive volatility or prevent the rate from moving too far from a desired level.

Floating: central bank has full independence to set interest rates for domestic goals. Fixed: interest rates must be used to defend the peg, sacrificing domestic objectives. Managed float: partial independence.

It combines the benefits of floating (flexibility, monetary policy freedom) with some stability (central bank smooths extreme movements). Most major economies operate some form of managed float.

If the currency is under downward pressure, the central bank buys domestic currency (selling foreign reserves). If under upward pressure, it sells domestic currency (buying foreign currency). It can also raise/lower interest rates.

Through foreign exchange market operations (buying/selling domestic currency), adjusting interest rates, or using verbal guidance ("jawboning") to influence expectations. Intervention is occasional, not constant.

Fixed: requires large foreign currency reserves to defend the peg. Floating: no reserves needed as the market sets the rate. Managed: needs some reserves for occasional intervention.

Stability and certainty for international trade and investment. Businesses know the exact rate, which reduces exchange rate risk and encourages trade, FDI, and long-term contracts between countries.

To provide stability for trade and attract FDI; to anchor inflation expectations (pegging to a stable currency like the USD); and because their financial markets may be too thin for a well-functioning float.

Requires large foreign currency reserves; limits monetary policy freedom (interest rates must defend the peg); the rate may be set at the wrong level; and if the peg breaks, the adjustment can be sudden and destabilising.

A type of managed exchange rate where the central rate is adjusted regularly in small increments (crawls), often tied to inflation differentials. It provides gradual adjustment rather than sudden devaluations.

Size and openness of the economy, level of development, foreign reserve holdings, inflation history, trading partners' systems, and the credibility of the central bank. There is no one-size-fits-all answer.

Devaluation: the government deliberately lowers the fixed rate (makes currency cheaper). Revaluation: the government raises the fixed rate (makes currency more expensive). These are deliberate policy changes, unlike market-driven appreciation/depreciation.

Lack of transparency — it is unclear when or why the central bank will intervene. This uncertainty can invite speculation and make it difficult for businesses to plan. Some argue it is the "worst of both worlds" if poorly managed.

After a currency depreciation, the current account initially worsens before improving, tracing a J-shape over time. This happens because volumes (quantities) adjust more slowly than prices.

Exports become cheaper in foreign markets (priced in foreign currency), so demand for exports increases. This benefits export industries and can improve the current account balance.

Exports become more expensive in foreign markets, reducing demand for them. Export industries may lose competitiveness and face declining revenue and potential job losses.

Existing import contracts are priced in foreign currency, so import bills rise immediately. Export volumes take time to respond because firms need time to increase production and foreign buyers need time to adjust purchasing patterns.

Imported goods become cheaper, increasing consumer purchasing power and choice. This keeps domestic inflation low and forces domestic firms to become more efficient to compete with cheaper imports.

Imports become more expensive in domestic currency, so demand for imports falls. Consumers switch to domestically produced substitutes if available, reducing spending on foreign goods.

Over time, the lower prices attract more export demand and consumers switch away from expensive imports to domestic substitutes. Demand becomes more elastic in the long run, so the trade balance improves.

It tends to worsen the current account: export revenue falls (less competitive abroad) and import spending rises (cheaper foreign goods). The trade deficit may widen.

More expensive imports raise the cost of imported raw materials and consumer goods, triggering cost-push inflation. The extent depends on import dependency — countries that import heavily (e.g. energy, food) are more vulnerable.

Depreciation can boost AD (net exports component rises) and stimulate growth in the short run. However, if it triggers inflation, central banks may raise interest rates, offsetting the growth effect.

Depreciation will improve the current account only if the sum of price elasticities of demand for exports and imports is greater than 1 (PED_X + PED_M > 1). If demand is inelastic, depreciation worsens the balance.

Exporting firms suffer (lose competitiveness), while firms that import raw materials benefit from lower input costs. Import-competing firms face tougher competition from cheaper foreign goods.

Yes. Cheaper imports reduce cost-push inflation and increase competitive pressure on domestic firms to keep prices low. Central banks sometimes welcome gradual appreciation as an anti-inflationary tool.

Not necessarily. It depends on the price elasticity of demand for exports and imports. If demand is inelastic (e.g. essential imports like oil), the trade balance may worsen initially before improving (J-curve effect).

Estimates vary, but the initial worsening phase typically lasts 6 to 18 months. The speed depends on how quickly firms and consumers adjust, the availability of domestic substitutes, and the nature of trade contracts.