Exchange Rates

What Are Exchange Rates?

The global currency market is worth 7.5 trillion dollars a day and how differences in interest rates, trade, and investment determine the value of the dollar in other countries.

On September 26, 2022, the British pound fell to $1.035 against the US dollar - its lowest value ever recorded. This was caused by Chancellor Kwasi Kwarteng's "mini-budget" two days prior. It was a collection of roughly 45 billion pounds of tax cuts that hadn't been budgeted for, and it worried both people trading currencies and those dealing with bonds. Within hours, hedge funds and big investors sold off a huge amount of pounds. The Bank of England had to quickly buy government bonds (gilts) to calm the bond market. Kwarteng himself was fired within weeks. The whole thing very clearly showed just how quickly the foreign exchange (forex) market can severely punish a mistake in government policy. More than $7.5 trillion is exchanged on this market every day, far more than all the world's stock markets together.

An exchange rate is simply a price, showing how much of one currency you get for another. When people outside the US want to buy American goods, services or investments, they need dollars. So, a BMW factory in Munich needing American microchips for its cars will need dollars to pay the company supplying them. A Japanese pension fund buying US government bonds also needs dollars to complete the deal. Every time someone from another country buys something from America, or an American asset, it creates a demand for dollars on the forex market.

Americans, on the other hand, supply dollars when they buy things from other countries, or go there. Buying a car from Germany, electronics from Korea, or a holiday in Mexico means sending dollars into the forex market, and receiving euros, won or pesos in return. It's a normal case of supply and demand. The point where the amount of dollars people want to buy is equal to the amount of dollars people are selling, is where the exchange rate is set. On a graph, the dollar price in terms of another currency (euros per dollar) goes on the up and down line, and the amount of dollars being traded goes on the left to right line.

Appreciation and Depreciation

Throughout most of 2022, the dollar became much stronger compared to almost all of the main currencies. The euro dropped below being equal to the dollar (something that hadn't happened for twenty years) meaning you got more than one euro for one dollar. The Japanese yen fell to 150 to the dollar, a rate not seen since 1990. And as we've said, the British pound reached its lowest point ever. The dollar was so strong that the DXY index - which measures the dollar against six major currencies - reached its highest level in twenty years. This overall strengthening is called appreciation, because each dollar buys more of a foreign currency than it did before.

And this change in value affects trade. If the exchange rate goes from 1.00 to 1.20 euros per dollar, an American product costing Europeans 100 euros when the rate was 1.00 will now cost them 120 euros. US goods for sale abroad get pricier, and so people in other countries buy fewer of them. However, a German item costing 100 euros now costs roughly $83 for Americans. Imports become cheaper, and so Americans buy more of them.

A depreciation does the opposite of all that. When the yen dropped to more than 150 per dollar in late 2022, goods made in Japan - cars, electronics, machinery - were very cheap for Americans. At the same time, American products priced in dollars became very expensive in shops in Tokyo. A weaker currency helps exports and makes imports more costly, so net exports go up. Because of this, countries sometimes deliberately weaken their own currency to help them sell more abroad (competitive devaluation), though this can lead to other countries doing the same and both the IMF and WTO dislike it.

What Causes Exchange Rates to Change

What causes demand and supply of currencies to change? Five things do, and they come up a lot on the AP Macroeconomics exam. Each of these affects either the demand for a currency, the supply of it, or both in the foreign exchange market (forex).

Differences in interest rates are a big one. Throughout 2022 and 2023, the Federal Reserve raised interest rates quite a bit, taking them from almost zero to over 5 percent. The European Central Bank increased rates, but more slowly and by smaller amounts. Because of the higher returns on American bonds and other assets paid in dollars, investors from other countries bought lots of dollars. As a result, the dollar's value went up against the euro, going from around 0.88 euros per dollar at the beginning of 2022 to more than 1.03 by September. In fact, interest rate differences are usually the strongest, fastest-acting factor in exchange rate changes.

How fast incomes grow in different countries matters too. If the American economy grows faster than Japan's, Americans will buy more Japanese cars, electronics, and other things. This means more dollars are sold for yen in the forex market, increasing the supply of dollars (a shift to the right). This causes the dollar to fall in value. But if Japan's economy is doing really well, Japanese people will buy more American products, which increases demand for dollars and makes the dollar go up.

Inflation rate differences are also important. If the U.S. has higher inflation than other countries, American products become more expensive for people in those countries. They'll buy fewer American goods, decreasing demand for dollars (shifting demand to the left). At the same time, Americans will start buying cheaper goods from other countries, increasing the supply of dollars (shifting supply to the right). Both of these things cause the dollar to lose value. During the 1970s, the U.S. had consistently higher inflation than its trading partners and, as a result, the dollar lost about half its value against the German mark between 1971 and 1979.

Speculation and what people think will happen with currency values are also key. Currency traders don't need to see official statistics. If they think the Fed is going to raise rates next month, they'll buy dollars now, which immediately increases demand for the dollar and causes the increase in value they were expecting. Forex markets have a lot of what you could call self-fulfilling prophecies, more so than most other markets.

Finally, tastes and preferences play a role. If people around the world suddenly want a lot more American technology, demand for dollars from abroad will go up. Conversely, if Americans start buying a lot more European luxury items, more dollars will be supplied to the forex market. Changes in preference move the demand and supply curves, but typically aren't as quick to act as interest rates or speculation.

Exchange Rates and the Current Account

Now, how do exchange rates relate to the current account?

A strong dollar is bad for American companies that make things, and the way this happens is directly through net exports (exports minus imports) - which is a direct part of total demand in the economy.

When the dollar's value increases, American products cost more for people in other countries, so exports go down. Goods from other countries cost fewer dollars, so imports go up. This reduces net exports. In 2022, the dollar was at its highest in twenty years, and Caterpillar said that changes in exchange rates reduced their income by about $700 million. Procter & Gamble said that foreign exchange rates caused a $1.2 billion reduction in their earnings. Companies that make a lot of money in other countries found their profits shrinking because when they changed those earnings back into dollars, the strong dollar meant they got less.

A falling dollar has the opposite effect. Exports become cheaper for people in other countries, so they buy more. Imports become more expensive for Americans, so we buy fewer. Net exports go up.

And this has a direct effect on total demand: AD = C + I + G + NX. If the dollar rises and lowers net exports, it moves the whole demand curve to the left - this decreases demand. If the dollar falls and raises net exports, it moves demand to the right - this increases demand. The forex market isn't separate from everything else in finance. Changes in exchange rates go directly into the calculation of GDP through net exports. And the AP exam will test you on this connection over and over.

Balance of Payments and Monetary Policy

What goes on with exchange rates and money flowing into and out of countries is really two sides of the same financial picture. If a country buys more from other countries than it sells to them (a current account deficit), it has to get enough money from overseas to make up for the difference, and this shows as a surplus in the capital account. The United States has been doing this for a long time, with its ongoing trade shortfall covered by a lot of foreign buying of Treasury bonds, shares in companies, and property in the US.

The AP exam focuses on this order of events more than nearly anything else in this section: interest rates, then exchange rates, and then the difference between a country's exports and imports. If the Federal Reserve (the Fed) increases interest rates, investors in other countries looking for better returns will buy US bonds. To do this, they need dollars, and as a result, demand for dollars goes up in the currency exchange market. This causes the dollar to become more valuable. A stronger dollar makes things made in the US more expensive for people in other countries, and foreign goods cheaper for Americans. Consequently, the country's exports relative to its imports will fall.

This chain of events shows a second way monetary policy has an effect, and this effect goes beyond the US. When the Fed raises rates, the obvious effect domestically is that investment goes down because of the higher cost of borrowing. The less obvious effect internationally is that the dollar gains value, and net exports decrease. Both of these outcomes reduce spending, and they work together, actually increasing the Fed's attempt to reduce overall demand.

If you go in the opposite direction for a policy to increase economic activity, the Fed lowers interest rates. The return on investments in dollars goes down, so foreign investors either take their money out or invest less. Demand for dollars falls, the dollar becomes cheaper, and exports go up while imports go down, increasing net exports. The boost to the US economy from cheaper borrowing is added to by the effect on exchange rates; both parts of this work to stimulate the economy.

Worked Example

Let's look at an example. The Fed increases the federal funds rate from 3% to 5%.

Money flows. US bonds now pay 5% instead of 3%. A German pension fund with 50 billion euros to invest notices a 3% difference between US and European bond rates. Money goes to where it gets a better return. Foreign investors rush to buy US Treasury bonds, bonds issued by US companies, and other assets valued in dollars.

Currency Exchange Market. To buy these US bonds, foreign investors need dollars. Demand for dollars on the currency market increases (shifts to the right). The exchange rate goes from 0.90 to 1.05 euros for every dollar.

Prices of Exports and Imports. An American product costing $100, which used to cost European buyers 90 euros, now costs 105 euros. US exports become a lot pricier for people abroad. At the same time, European products are cheaper for Americans. An item from Europe costing 100 euros used to cost $111, but now costs about $95. Imports go up, exports go down.

Net Exports and Overall Demand. Falling net exports reduce overall demand, and this reinforces the economy-slowing effect of the interest rate increase, happening along with the reduction in domestic investment. Both the exchange rate effect and the investment effect work to slow the economy.

The AP exam usually gives you one step in this process and asks you to explain what happens next. The order you need to remember is: interest rates increase → money comes into the country → the dollar gets stronger → net exports fall → overall demand decreases (the demand curve shifts to the left).