No country is an island. Goods, services, and money cross borders every second, and the bridge between economies is the price of one currency in terms of another. Studying how those flows fit together is the job of the open economy — the analysis of an economy that trades and invests with the rest of the world.
Start with the price of money itself. The nominal exchange rate is simply how many units of one currency you get for another, like 1.1 dollars per euro. The real exchange rate goes deeper. It adjusts for price levels in both countries, telling you how much of a foreign basket of goods your money can actually buy. The nominal rate moves daily; the real rate tells you whether your purchasing power abroad truly rose or fell.
Exchange rates move for clear reasons. Higher interest rates at home attract foreign money and strengthen the currency. Faster inflation weakens it. A surge in demand for exports lifts it. Expectations and speculation push it around in the short run, sometimes violently.
A currency change does not work the way you might guess. Picture a country whose currency suddenly weakens. In theory its exports get cheaper and its trade balance should improve. But it gets worse first. This is the J-curve — the pattern where a weaker currency worsens the trade balance before improving it, because contracts and buying habits take time to respond while import bills rise immediately.
To track all the flows, economists split a country's dealings with the world into accounts. The current account records trade in goods and services plus income from abroad. The capital and financial account records investment flows, money buying assets across borders. Together they make up the balance of payments, and by construction the two accounts must sum to zero. A country that imports more than it exports must be borrowing or selling assets to cover the difference.
Countries also choose how to manage their currency. Under a floating regime the market sets the rate, which rises and falls freely. Under a fixed regime the government pegs the rate to another currency and defends it, buying and selling to hold it in place. Each choice has costs and benefits.
The choice runs into a hard constraint, one of the elegant results in macro. The impossible trinity says a country can have at most two of three things at once: a fixed exchange rate, free movement of capital across its borders, and an independent monetary policy. Want all three and something has to give. This single insight explains many of the great currency crises in modern history.