What is an exchange rate?
An exchange rate is the price of one currency measured in terms of another. For example, if 1 US dollar buys 4 Malaysian ringgit (RM), then RM 4 is the exchange rate against the US dollar.
Key idea
Under a floating exchange rate, the value of a currency is set by the demand for and supply of that currency on the foreign exchange market.
Appreciation and depreciation
When a floating currency rises in value it appreciates; when it falls it depreciates. Demand for a currency rises when foreigners buy that country's exports or invest there, or when interest rates rise and attract foreign savings (sometimes called hot money).
Example
If the ringgit depreciates, exports priced in ringgit become cheaper for foreign buyers, so exports tend to rise. At the same time imports become dearer at home.
Effects on trade
A useful memory aid is SPICED: Strong Pound (a strong or appreciating currency) means Imports Cheaper, Exports Dearer. A depreciation does the opposite — it helps exporters but raises the price of imported goods.
Some governments prefer a fixed exchange rate, where the central bank keeps the currency at a set value by buying or selling foreign currency reserves. A fixed rate gives firms certainty when they plan trade, but it can be hard and costly to defend if markets push the currency the other way. Whichever system is used, a change in the exchange rate feeds straight through to the prices of a country's exports and imports, and so affects its trade and jobs.
Remember
- Appreciation = rise in value; depreciation = fall in value.
- Depreciation makes exports cheaper and imports dearer.