# How do exchange rates work?

We have already talked about how money works in a previous article, however, the concepts presented mainly apply to their value inside the country. What about the value of money between countries? Today we are going to talk about exchange rates.

## The basics

The exchange rate is the proportion ratio that exists between the value of two currencies. For example, today’s exchange rate from euros to dollars is 1.1171. This means that a euro is worth the same as a dollar with twelve cents.

Exchange rates are expressed in currency pairs followed by the number, the previous example would be expressed as follows:

EUR / USD 1.1171

The first currency (Euro / EUR) is converted to the value of the second currency (US Dollar / USD). If we swap them, the result would be this:

USD / EUR 0.8956

In this case, a dollar is worth ninety cents.

If we return to January 3 of 2014, we would see that the EUR / USD rate was 1.3589, that is, it was higher than today. That means the euro has depreciated against the dollar. If the rate had increased then we would say that the currency appreciated.

Appreciation and depreciation can also be called respectively revaluation and devaluation depending on the exchange-rate regime of the country, we will talk about that later.

Now let’s see what defines the value of one currency against another.

## What defines the exchange rate?

### Supply and demand

In the article “How does money work?” We established that the value of a currency is defined mainly by the money supply (that is, the amount of money circulating), and in the medium / long term by economic activity, which in a nutshell is the same as the money demand (If people are buying more things, they need more money).

When talking about exchange rates, the supply continues to play an important role. If a central bank prints large amounts of money the currency will inevitably depreciate. However, demand now plays a much larger role.

Countries with greater economic activity tend to have the strongest currencies, and as we said before, economic activity has a strong relation with the demand for money.

But money is not only demanded within the country. People from other countries demand our currency and we demand foreign currencies. Why?

### Exports and imports

Let’s say you’re an entrepreneur on a small rocky island and you want to open a burger joint. Unfortunately, the island is useless for raising livestock, the only animals you find there are seabirds and bats.

So you have to import meat from the United States. But American farmers only accept dollars. So you get dollars and with them buy the meat, now the island is importing meat.

Imports imply a growth in the demand for dollars. This increase in the demand for foreign currency causes the local currency to depreciate. That is, the exchange rate rises.

The burger joint has been a success! But steady meat imports have weakened the island’s currency, which means that meat is now more expensive and that is affecting your earnings. It’s time to look for a new market.

Luckily the island’s currency (let’s call it Island Dollar or ISD) is now quite weak, which makes it the perfect time to sell local products to other countries, ie export.

The large population of seabirds and bats makes the island the perfect place to acquire guano. A powerful natural fertilizer taken from the feces of these animals.

Now we have two options, farmers from other countries who want to buy your guano can buy ISD and pay you with that, or you can accept their dollars and exchange them whenever you want. (There are advantages to doing that, which we will explain later).

No matter what you decide, now demand for ISD will increase thanks to the guano exports and this will lead to an ISD appreciation.

The subtraction between the value of exports and imports is what is called the trade balance. A trade surplus is when you export more than you import, this appreciates the value of the currency. On the other hand, we have a trade deficit when we import more than what is exported, the result of this is a depreciation.

The economy of the island has been flourishing. Unfortunately, a combination of poor economic policies has generated a situation of high inflation, deteriorating the purchasing power of the population. How does this affect the exchange rate?

Here enters the concept of real exchange rate. Which is the relation between the cost of the same basket of products in two different places.

Let’s say that this basket of products in the United States has a value of 1000USD and in the island is 1500ISD. This means that the real USD / ISD exchange rate is 1.5, but the island’s inflation situation has led to the same basket costing 2000ISD, so the real exchange rate increases to 2. The ISD is depreciating.

The exchange rate in the market is rarely the same as the real exchange rate. But in general terms both follow the same trends, if a country has high levels of inflation then it’s likely that its currency will depreciate.

### Interest rates and public debt

Assume that the central bank of the island raises interest rates to control inflation. Hopefully, this action will also prevent the currency from further depreciating.

However, there is another effect at work here; loans and returns to investments.

High-interest rates attract foreign investors and lenders, who see a business opportunity in acquiring ISD to buy bonds that offer them high returns.

As we know, an increase in the demand for the local currency leads to an appreciation.

On the other hand, let’s say that the government of the island acquires a large loan to finance social projects, that’s good, right?

It depends on the government’s ability to repay such loan, if foreign investors see the possibility of the government printing money to pay off debt (generating inflation) or even the possibility of not paying it at all, then they will avoid buying bonds or investing in the country, depreciating the currency.

So far we have talked about exchange rates in terms of what is called a floating exchange rate, but there are other currency regimes used around the world. Let’s take a look.

## Exchange rate regimes

### Floating exchange rate

There is not much to say about floating exchange rates, they are the ones that we have talked about so far and are the most used ones around the world.

Floating exchange rates are those that are decided mainly by the market with minimal intervention from the government or central bank.

When the central bank intervenes to prevent the exchange rate from fluctuating too wildly then it is said to be a directed or dirty exchange rate.

### Fixed exchange rate

Let’s go back to the island. Guano exports have generated an economic boom and the standard of living of the population has improved considerably.

However, the nature of the trade surpluses is causing the ISD to appreciate, making revenues from the sale of guano increasingly smaller.

This isn’t convenient for the government, which has an interest in keeping those dollars coming in. So they decide to establish a fixed exchange rate.

A fixed exchange rate implies that the government now decides the relationship between USD / ISD, not the market.

When the government or central bank is the one that decides the exchange rate, we no longer talk about appreciation and depreciation, now we use the terms revaluation and devaluation are used.

The problem with fixed exchange rates is that they are not representative of the market, and if the difference between the fixed rate and the market rate is too large it will lead to the creation of a currency black market.

So how do we make the market exchange rate as close as possible to the fixed exchange rate? With international reserves.

International reserves are foreign currency deposits held by the central bank. How is the exchange rate controlled with these reserves?

When there is a lot of demand for dollars the central bank floods the market with the money necessary to maintain the exchange rate in the value that was determined.

Likewise, when there is excess supply (when there are more dollars in the market than are being demanded) the central bank buys dollars to prevent the exchange rate from decreasing.

And what happens when the central bank does not have the international reserves needed to maintain the value of the fixed currency?

They could keep the fixed rate by decree, but this would inevitably lead to the creation of a black market.

They could also devalue or revalue the currency so that keeping the rate is not as expensive.

Or they could abandon the fixed rate and adopt a floating system. Most countries that have tried to establish fixed exchange rates have ended up abandoning them because of their inability to defend the rate against market conditions or speculative attacks.

### Crawling Bands

The crawling band system is a more flexible version of the fixed exchange rate.

This system establishes a midpoint for the exchange rate band (which would be similar to the fixed exchange rate) and then establishes a range in which the rate can vary.

If the exchange rate touches the floor or ceiling of the bands, then the central bank has to use its international reserves to defend the value of the currency. In the same way that would be done with a fixed exchange rate system.

This system gives the central bank more flexibility and is easier to maintain than a fixed exchange rate, but in the long run it remains vulnerable to market conditions and speculative attacks.

An example of this was the Black Wednesday of 1992, when billionaire George Soros broke the UK’s exchange bands by flooding the British pound market, forcing the country to withdraw from the European Exchange Rate Mechanism.

## Summary

• The exchange rate is the proportion ratio that exists between the value of two currencies.
• A strong currency favors imports, on the other hand a weak currency is better for exports.
• However exports strengthen the currency, while imports weaken it.
• A stronger currency is said to be appreciated, when it is strengthened due to an action from the central bank we speak of revaluation.
• On the other hand a weakening currency is depreciating, and if this was a decision of the central bank then it is a devaluation.
• Inflation, high public debt and low interest rates are other factors that weaken a currency.
• When exchange rates are defined by the market we speak of a floating exchange rate, when they are set by the central bank it is a fixed exchange rate.
• The central bank can control the exchange rate by using its international reserves; Buying dollars when there is a lot of supply and selling them when there is a lot of demand.

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