💱 What Is an Exchange Rate?
Definition: Exchange rate.
Floating exchange rate.
In a floating system, currencies are traded 24/7 on the foreign exchange (forex) market. The price fluctuates constantly based on relative demand and supply.
Appreciation = currency becomes stronger (can buy more foreign currency). Depreciation = currency becomes weaker (can buy less foreign currency). These terms apply to floating rates.
📊 Demand and Supply of a Currency
Demand for a currency increases when...
- Foreign demand for exports rises — foreigners need the currency to buy the country's goods.
- Inward FDI increases — foreign firms invest in the country, buying the domestic currency.
- Higher interest rates — attract 'hot money' flows from investors seeking better returns.
- Speculation — traders expect the currency to appreciate, increasing demand now.
- Tourism — foreign tourists exchange their currency to visit.
Supply of a currency increases when...
- Demand for imports rises — domestic consumers/firms sell domestic currency to buy foreign goods.
- Outward investment — domestic firms invest abroad, selling the domestic currency.
- Lower relative interest rates — capital flows out seeking better returns elsewhere.
- Speculation — traders expect the currency to depreciate, selling it.
IB diagram: Draw the forex market with the exchange rate on the Y-axis and Quantity of currency on the X-axis. Show D and S curves with the equilibrium exchange rate. Shift the relevant curve to show changes.
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⚖️ Floating Rates: Pros and Cons
- ✅ Automatic adjustment — trade imbalances self-correct. A current account deficit → depreciation → exports become cheaper → deficit reduces.
- ✅ Monetary policy freedom — the central bank can set interest rates for domestic goals (inflation, growth) without worrying about maintaining the exchange rate.
- ✅ No need for large foreign currency reserves — the government doesn't need to defend a fixed rate.
- ❌ Uncertainty and volatility — exchange rate fluctuations create risk for international traders and investors.
- ❌ Speculative attacks — 'hot money' flows can cause sharp, destabilising movements.
- ❌ Imported inflation — a depreciating currency makes imports more expensive, fuelling cost-push inflation.