Definition
An exchange rate is the price at which one currency can be exchanged for another — e.g., 1 US dollar buys 0.92 euros, or 1 British pound buys 1.27 dollars. Exchange rates are prices, determined in foreign exchange markets by the same supply and demand forces that govern other prices. A currency "appreciates" when it buys more of other currencies; it "depreciates" when it buys less.
Unlike most prices, exchange rates affect entire economies simultaneously. A dollar appreciation makes US exports more expensive for foreign buyers (reducing demand) and makes imports cheaper for American consumers (reducing domestic producer competitiveness). The exchange rate thus links domestic monetary policy, inflation, and trade balances to the global economy in ways that no purely domestic price does.
Why it matters
What moves exchange rates
Fixed vs. floating exchange rate regimes
Floating exchange rates
In a floating regime (used by the US, UK, EU, Japan, Canada, and most major economies), the exchange rate is determined by market supply and demand. The central bank does not target the rate but may intervene occasionally to smooth excessive volatility. Floating rates adjust automatically to trade imbalances and absorb external shocks — a depreciation following a recession makes exports cheaper and helps the recovery without requiring internal wage cuts.
Fixed exchange rates
In a fixed regime, the central bank commits to maintaining a specific exchange rate by buying or selling foreign currency reserves. Hong Kong fixes to the dollar; many small open economies peg to a major trading partner's currency. The discipline of a peg can reduce inflation (imported credibility from the anchor currency) but at the cost of monetary policy independence: the domestic interest rate must track the anchor country's rate to prevent capital flight or inflows.
Exchange rates and inflation
A currency depreciation raises import prices, pushing up the domestic price level — "imported inflation." For countries that import significant amounts of food, energy, or consumer goods, exchange rate movements can substantially affect the inflation rate. Central banks in small open economies monitor the exchange rate closely as a second inflation transmission channel alongside the domestic interest rate.