Exchange rates change when demand for exports or imports changes, when interest rates change, or when speculators act.
Changes in demand for exports and imports: if foreigners buy more of a country's exports, they need more of its currency. Demand for the currency rises and it appreciates. If residents buy more imports, they sell more of their currency, so supply rises and it depreciates.
Changes in interest rates: if a country's interest rates rise relative to others, saving there becomes more attractive. Foreign savers buy its currency to deposit money in its banks, so the currency appreciates.
Speculation: if speculators expect a currency to rise, they buy it now, which increases demand and causes it to rise. Expectations can become self-fulfilling.
Government intervention, such as a central bank buying its own currency, can also change the rate.
- Exports rise
- Demand for the currency rises; appreciation.
- Imports rise
- Supply of the currency rises; depreciation.
- Higher interest rates
- Attract foreign savings; appreciation.
- Speculation
- Expected rises can cause actual rises.
Worked example: Explaining an appreciation
Suppose world demand for Singapore's pharmaceuticals rises strongly.
- Foreign buyers need S$ to pay Singapore firms.
- Demand for S$ rises: the demand curve shifts right from D0 to D1.
- At the old rate there is excess demand for S$, so its price rises.
- The S$ appreciates from ER0 to ER1.
Watch out for this
A rise in a country's interest rate makes its currency depreciate.
Higher interest rates attract foreign savings, which increases demand for the currency, so it usually appreciates.
Check your understanding
A country's central bank raises interest rates while other countries keep theirs the same. What is likely to happen to its currency?
- It appreciates, as foreign savers buy it.
- It depreciates, as residents sell it.
- It stays the same, because interest rates do not matter.