Exchange rates are the domestic price of a unit of foreign currency. Exchange rates impact international trade, part of a country’s CIRCULAR FLOW MODEL of economic output and INCOME. When the value of a country’s currency rises relative to another country’s currency, the currency is said to have appreciated. Likewise, when a currency decreases in value relative to another currency, it has depreciated. For most of the 1990s and early 21st century, the U.S. dollar appreciated against most of the other world currencies. For example, on January 9, 1998, the Canadian dollar was worth 0.6992 U.S. dollars; on April 30, 2001, it was worth 0.6483 U.S. dollars, 7.3 percent less than a little over three years earlier. The same relationship can be expressed in terms of how many Canadian dollars are required to be exchanged for one U.S. dollar. In 1998, 1.4303 Canadian dollars equaled one U.S. dollar, while in 2001 it took 1.5425 Canadian dollars to equal one U.S. dollar. Two important questions when studying exchange rates are: What is the impact of appreciating and depreciating currencies, and what exchange-rate policies can and do governments pursue? When a country’s currency appreciates, its exports become more expensive to foreign buyers and IMPORTS become less expensive. This increases DEMAND for imports and decreases demand for exports. In recent years the U.S. TRADE BALANCE, both the merchandise trade balance and the current account, have been negative, reflecting the relative value of the U.S. dollar against world currencies. In 2003 the United States’ current account deficit was approximately $400 billion, meaning foreigners held more ($400 billion worth) claims against the U.S. output than U.S. sellers had against foreign output. Ceteris paribus (other things being equal), the U.S. dollar should fall in value as foreigners increase the supply of U.S. dollars in exchange markets and increase demand for their currencies. Instead foreigners have been buying U.S. securities, both government BONDS and corporate stocks and bonds, and purchasing U.S. ASSETS, mostly U.S. companies. Because foreigners are not exchanging the U.S. dollars, the value of the dollar has not declined. Economists are quite concerned about the potential impact of a change in international investment in the United States. A sudden shift in international sentiment would decrease the supply of investment CAPITAL and thus the value of the dollar in world markets, increasing the price of imports and adding to INFLATION. This can happen in a system of floating exchange rates. Since 1973, when the gold standard created at BRETTON WOODS at the end of World War II was abandoned, a variety of exchange-rate policies have evolved in world trade, including floating, fixed, pegged, and managed floating exchange-rate systems. Floating exchange-rate systems, as stated earlier, allow SUPPLY and DEMAND for a country’s currency to determine the exchange rate. Floating exchange rates create uncertainty for businesses engaged in foreign trade, allow countries to pursue independent economic policies, and tend to ease balance-of-payments adjustments. Fixed exchangerate systems reduce business uncertainty but require government intervention to maintain the fixed exchange rate (buying or selling currencies to adjust for the imbalance of supply and demand for the currency). If two countries have similar rates of inflation, they will be able to maintain a fixed exchange-rate policy. If one country’s inflation rate is consistently greater than the other country’s inflation rate, the first country’s currency will be overvalued in a fixed exchange-rate system. The PESO CRISIS was largely a result of higher inflation in Mexico than in the United States, without sufficient devaluation of the Mexican peso. At the time of the peso crisis (1994), Mexico had a crawling-peg exchange-rate system: a predetermined monthly rate of DEPRECIATION of the peso against the U.S. dollar. Some countries that have experienced rapid inflation have “pegged” their currency to another country’s currency, creating a fixed exchange rate. Argentina and Ecuador pegged their currencies to the U.S. dollar. Many former French colonies peg their currencies to the French franc. The EUROPEAN UNION, through the European Monetary System, negotiated a fixed exchange rate among the participating members and a floating exchange rate with respect to the rest of the world. Not all members of the EU agreed to the terms of the historic Maastricht Treaty, but those that did agreed to coordinate domestic macroeconomic policies including budget deficits and inflation rates as part of agreement to create a unified currency.
See also EXCHANGE-RATE RISK; FOREIGN EXCHANGE; MACROECONOMICS.