Exchange Rates & Protectionism

Exchange rates

The exchange rate is the price of one currency in terms of another, set in the foreign-exchange market by the demand for and supply of the currency. Demand for a currency comes from foreigners buying its exports and assets; supply comes from residents buying imports and foreign assets.

Systems: a floating rate is set freely by the market; a fixed rate is pegged by the central bank using reserves and interest rates; a managed float is mostly market-determined with occasional intervention.

Depreciation/devaluation (the currency falls): exports cheaper abroad, imports dearer — using the shorthand SPICED (Strong Pound = Imports Cheaper, Exports Dearer; a weaker pound is the reverse). A weaker currency tends to improve the current account (subject to the Marshall–Lerner condition that the sum of export and import demand elasticities exceeds 1) but raises imported inflation.
Appreciation/revaluation (the currency rises): exports dearer, imports cheaper — worsening competitiveness but reducing imported inflation.

Determinants of demand/supply: relative interest rates (hot money flows), relative inflation/competitiveness, trade flows, investment (FDI), speculation and confidence.