Lesson preview · Exchange rates and the balance of payments
Why currencies rise and fall
~7 min · Free to read
At the start of 2022, one US dollar bought about 115 Japanese yen. In July 2024, at its peak, a dollar bought about 161 yen.
Before any fees, 1,000 dollars went from about 115,000 yen to about 161,000: 40% more yen to spend on trains, meals and hotels. For families in Japan, holidays abroad and imported goods got dearer. Why do currencies move like this, and who wins when they do?
Key Term
Exchange rates: the price of a currency
An exchange rate is the price of one currency in another, such as 161 yen per dollar.
- A currency appreciates (gets stronger) when each unit buys more of another currency.
- It depreciates (gets weaker) when each unit buys less.
From 2022 to 2024, the dollar appreciated against the yen, and the yen depreciated against the dollar. That’s one change, seen from each side.
Banks and traders swap currencies in the foreign exchange market.
Who wants yen? Foreigners buying Japanese exports, such as cars and games. Tourists visiting Japan. And foreign savers buying Japanese assets, things that earn their owner money, such as shares and bonds. A bond is a loan to a government or firm that pays interest. They make up the demand for yen.
People in Japan sell yen to pay for imports, holidays abroad or foreign assets. They make up the supply of yen.
An interest rate is what savers earn each year, as a percentage of their savings. When a country’s interest rates rise compared with rates abroad, its savings accounts and bonds pay more. Savers abroad move money there, buying that country’s currency first. Demand for the currency rises, so it appreciates.
By July 2023, the US central bank’s main interest rate was above 5%, up from almost zero in early 2022. Japan’s main rate stayed just below zero (−0.1%) until March 2024. That gap gave savers a reason to swap yen for dollars, and it helps explain the yen’s fall.
Many currencies float: supply and demand set the rate, and it changes every day. Some governments fix (or peg) the rate instead. The central bank then buys and sells its own currency, using its reserves of foreign currency, to hold the rate in place. Hong Kong has linked its dollar to the US dollar since October 1983. Since 2005, it has kept the rate between 7.75 and 7.85 Hong Kong dollars per US dollar.
Key Term
Stronger or weaker: who wins?
When a country’s currency appreciates:
- imports get cheaper, so shoppers and firms that buy from abroad gain;
- its exports get dearer for foreign buyers, so exporters sell less;
- holidays abroad get cheaper for its people, but visiting the country gets dearer for foreign tourists.
A depreciation does the opposite: exporters and tourism firms gain, and importers lose.
Each change moved one line, and the exchange rate moved until supply and demand matched again. That’s all a floating exchange rate is: a price set by the people buying and selling a currency.
Trap · Common Misconception
"The number went up, so the currency got stronger"
A rate can be written either way round. When yen per dollar rose from 115 to 161, the number went up, but the yen got weaker: each yen bought less. Always ask what one unit of the currency buys. If that rises, it has appreciated.
Tip
Changing money costs money
Banks and exchange booths charge for swapping currencies: a fee, a worse rate than the market’s, or both. At 0.90 euros per dollar, 500 dollars buys 450 euros. Take off a 3% fee and you get 450 − 13.50 = 436.50 euros.
Tip
Drawing the diagram
Label the vertical axis “Exchange rate”, with the units, such as “euros per dollar”. Never label it “Price”. Label the horizontal axis “Quantity of dollars”.
Worked Example
Imagine a Japanese firm sells a camera for 150,000 yen. A family in Japan wants a laptop that costs 1,000 dollars abroad. The yen depreciates from 100 to 150 yen per dollar. What happens to the camera’s price in dollars, and the laptop’s price in yen?
Practice · 1 / 6
Country X lets its currency float. What sets its exchange rate?
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