25 Why Exchange Rates Matter
Exchange rates may sound like a complex economic term, but they play a crucial role in our daily lives. Whether you’re booking a holiday, purchasing an imported gadget, or even filling up your car with fuel, the fluctuations in currency values can significantly impact what you pay.
Imagine you’re planning a trip abroad. The price of your flight ticket, hotel stay, and meals will all be influenced by the value of your local currency against the currency of your destination. If your currency weakens, your holiday suddenly becomes more expensive; if it strengthens, you might get more value for your money.
But it’s not just travel – no country in the world is entirely self-sufficient. Every country relies on imports and exports, whether it’s food, technology, or energy. Some nations are more dependent on foreign goods than others, but no matter where you live, exchange rate fluctuations affect the cost of the products you consume.
Countries that heavily rely on imported technology and energy, for example, feel the effects of exchange rate changes even more. If their currency weakens, they have to pay more for fuel, electronics, and other essentials, which can lead to higher prices for consumers.
Simply put, an exchange rate tells you how much one country’s currency is worth compared to another. For instance, if 1 British pound equals 1.25 US dollars, it means you can exchange one pound for $1.25.
Some countries let their currency’s value float freely, meaning it changes based on supply and demand in global markets. Others try to fix their currency’s value to another, like the US dollar. But can a country simply decide its currency is worth more?
Let’s say the Bank of England suddenly declares, “From now on, 1 British pound will be worth 2 US dollars instead of 1.25.” It sounds great on paper. But in reality, this would create chaos.
If this new exchange rate were enforced, people would rush to exchange their pounds for dollars at this artificially high rate. Everyone holding British pounds would head straight to the central bank, demanding two dollars for each pound. Since the value of a currency is determined by market confidence and economic fundamentals, not just by government declarations, the central bank would quickly run out of dollars to hand out. The system would collapse, leading to a financial crisis.
This is not just a hypothetical scenario, many countries throughout history have attempted to artificially control exchange rates, only to face economic turmoil. Whether in Latin America, Asia, Europe, or Africa, the result is always the same: the market eventually corrects itself, often in painful ways.
Exchange rates are not just numbers on a financial chart, they shape the cost of living, travel, and trade for everyone. While governments and central banks can influence exchange rates to some extent, ultimately, market forces dictate their true value. So, the next time you book a holiday or buy an imported product, remember that the invisible force of exchange rates is at play behind the scenes!
Let’s say instead of setting an unrealistic exchange rate, the central bank decides to fix the value of 1 British pound at 1.25 US dollars, at its current market value. This is actually possible, and some countries do maintain fixed exchange rates.
For a country to successfully keep its exchange rate fixed, it needs a balanced international trade position. If a country earns as much foreign currency from exports as it spends on imports, or if it even runs a trade surplus – meaning it earns more from selling goods and services abroad than it spends on buying from other countries – then maintaining a fixed exchange rate is more manageable.
However, if a country consistently spends more foreign currency than it earns, this becomes a challenge. If imports exceed exports, there will be a shortage of foreign currency, making it difficult to maintain the fixed rate. In such cases, the central bank has to step in by supplying foreign currency to keep the exchange rate stable.
To do this, central banks hold reserves of foreign currencies, particularly US dollars. These reserves act as a buffer, allowing the central bank to intervene when needed by releasing foreign currency into the market or absorbing excess supply. But while this strategy can work temporarily, it’s not a sustainable solution for countries that continuously face trade deficits.
The most crucial factor here is that approximately 60% of global transactions are conducted in US dollars. This makes the dollar the most influential currency in international trade. The euro plays a significant role too, accounting for about 20% of transactions, while other currencies like the British pound contribute a much smaller share.
There are several types of exchange rate policies that countries may adopt, depending on their economic goals and external circumstances. These include fixed exchange rates, flexible (or floating) exchange rates, and managed float systems. In a fixed exchange rate system, the value of a country’s currency is officially set and maintained at a specific level relative to another currency, such as the US dollar or the euro. In contrast, under a flexible exchange rate system, the value of the currency is determined entirely by market forces – supply and demand in the foreign exchange market. A managed float (or dirty float) lies somewhere in between: the currency generally floats, but the central bank may intervene occasionally to stabilise or influence the exchange rate.
When a country chooses a fixed exchange rate regime, it is committing to maintaining a stable exchange rate against another currency. To achieve this, the country’s central bank must be prepared to buy or sell its own currency on the foreign exchange market as needed. However, this commitment comes at a cost: the country loses its independent monetary policy. The reason is straightforward. In order to maintain the fixed rate, the central bank must adjust its interest rates to match those of the country to which it has pegged its currency. It cannot use interest rate policy to respond freely to domestic conditions such as inflation, unemployment, or recession.
To illustrate this, consider a country that fixes its currency to the US dollar. If the United States raises interest rates to tackle inflation in its own economy, the pegged country must also raise its interest rates – even if its own economy is slowing down and would benefit from lower interest rates. Failing to do so could lead to capital outflows, downward pressure on the currency, and ultimately the collapse of the fixed exchange rate. As a result, countries with fixed exchange rates are highly dependent on the monetary policy of the anchor currency’s central bank – such as the US Federal Reserve or the European Central Bank. In effect, they become monetary policy followers, not leaders.
A real-world example of this is Hong Kong, which has maintained a fixed exchange rate against the US dollar since 1983. While the peg has helped maintain stability and investor confidence, it also means that the Hong Kong Monetary Authority must align its interest rate policy with that of the United States. In recent years, when the US raised interest rates aggressively to fight inflation, Hong Kong had to follow suit – despite facing very different economic conditions, such as lower inflation and slower growth.
Another historical example is the United Kingdom in the early 1990s, when it attempted to maintain a fixed exchange rate as part of the European Exchange Rate Mechanism (ERM). The UK had to keep interest rates high to defend the fixed exchange rate, even though its economy was already in a recession. Eventually, the pressure became too great, and the UK was forced to abandon the fixed rate in what became known as “Black Wednesday” in 1992.
For any country that fixes its currency’s value, what truly matters is how much it earns and spends in US dollars. If a nation has set its exchange rate and finds itself earning fewer dollars from exports than it needs to cover its imports, it faces a problem. Where will it get the missing dollars to maintain the fixed rate?
This shortage of dollars creates a major risk for countries that attempt to control their exchange rates. Without enough reserves, they may struggle to defend their fixed exchange rate, leading to economic instability or even a crisis. In a fixed exchange rate system, central banks play a crucial role in maintaining the target exchange rate, and to do so, they must hold substantial foreign currency reserves. These reserves typically consist of internationally accepted and widely traded currencies, such as the US dollar, the euro, the British pound, or the Japanese yen. The most common reserve currency in the world is the US dollar, largely because of its dominance in global trade, finance, and its perceived stability.
When a country fixes its exchange rate, it commits to exchanging its own currency for a specific amount of the anchor currency. Suppose the domestic currency comes under downward pressure – meaning that people are selling it in large volumes, perhaps due to lack of confidence or capital flight. To defend the fixed rate, the central bank must intervene in the foreign exchange market by selling its foreign reserves and buying back its own currency. This demand supports the domestic currency and keeps its value from falling below the target rate.
The effectiveness of this defence depends heavily on the size and strength of the country’s foreign reserves. If reserves are too low, the central bank may not be able to intervene successfully for long. In such cases, the fixed exchange rate can collapse, leading to a sudden and potentially damaging devaluation. This is why countries with fixed exchange rate systems often prioritise building up large reserves as a precautionary measure. However, accumulating reserves can come with costs – it may require the country to run persistent trade surpluses, borrow in foreign currency, or limit domestic spending in order to preserve reserve levels.
On the other hand, if the domestic currency is under upward pressure – meaning that foreign investors are buying it, perhaps because of high interest rates or economic confidence – the central bank will need to do the opposite: it buys foreign currency and issues domestic currency to prevent the exchange rate from rising. This expands the domestic money supply, which can lead to inflationary pressure unless it is sterilised (neutralised) through other monetary operations.
An example of a country with significant foreign reserves is China. For many years, China maintained a tightly managed exchange rate, keeping the renminbi (RMB) at a stable level against the US dollar. To achieve this, the People’s Bank of China accumulated trillions of dollars in foreign reserves, largely by buying US dollars and selling RMB. This gave China both the means to stabilise its currency and a significant presence in international financial markets. However, managing such a system also constrained China’s ability to run an independent monetary policy and led to international criticism over currency manipulation and trade imbalances.
Many countries allow their exchange rates to fluctuate freely, meaning the value of their currency is determined by supply and demand in the market. On the other hand, while some countries claim to operate under a freely floating exchange rate system, in practice many of them follow what is known as a managed float or dirty float. In this system, the exchange rate is in theory determined by market forces – supply and demand in the foreign exchange market – but in reality, the central bank frequently intervenes to influence the value of the currency in line with its own economic objectives.
This intervention may not be publicly announced or systematically explained, but it can take various forms: buying or selling foreign currencies, adjusting interest rates to influence capital flows, or using policy statements to shape market expectations. Central banks do this to prevent excessive volatility, protect export competitiveness, reduce inflationary pressures from imported goods, or maintain financial stability. While the system appears flexible, it is effectively a discretionary policy tool, allowing authorities to adjust the exchange rate as needed without committing to a fixed target.
A well-known example of this practice is India, where the Reserve Bank of India (RBI) officially maintains a floating exchange rate system. However, the RBI frequently intervenes in the currency markets to stabilise the rupee, especially during periods of high volatility or when sharp depreciation threatens inflation or investor confidence. Similarly, Singapore uses a managed float regime where the Monetary Authority of Singapore (MAS) does not target interest rates but instead actively manages the exchange rate within a policy band, which is not publicly disclosed.
This kind of exchange rate management offers more flexibility than a fixed system and allows countries to respond to changing economic conditions while avoiding the full volatility of a purely floating currency. However, it also requires careful monitoring, sufficient foreign exchange reserves, and credible policy communication to maintain market confidence.
Exchange rates are primarily influenced by the balance between how much a country needs foreign currency (especially US dollars) for imports and how much it earns in foreign currency from exports. If a country buys more goods and services from abroad than it sells, it runs a trade deficit, meaning it spends more foreign currency than it earns.
For every country that runs a trade deficit, another country must be running a surplus. The country with a deficit needs to figure out how to cover the shortfall, while the country with a surplus needs to decide what to do with its extra foreign currency. In an open market, capital naturally flows to places where it can earn the highest return. Countries that need foreign currency often attract investment by offering higher interest rates, making their financial markets more appealing to those holding surplus funds.
Interest rates play a key role in these movements. Countries at similar levels of economic development tend to compete with each other to attract foreign capital. For example, Indonesia, Mexico, and South Africa are often grouped together in the same economic category. If Mexico is running a trade deficit and its currency is losing value, it can raise interest rates to attract foreign investment. When investors bring their money into Mexico to take advantage of the higher returns, they need to exchange their dollars for Mexican pesos. This increased demand for the peso strengthens its value, helping to stabilise the exchange rate.
However, Mexico is not competing with Canada in this way. Developed economies like Canada already have lower interest rates because they are considered more stable – both economically and politically. Emerging economies, on the other hand, face greater risks, which is why they must offer higher interest rates to attract investors.
If a developing country wants to move up and become a more stable, high-income economy that no longer relies on high interest rates to attract capital, it must undergo deeper structural changes. As discussed throughout this book, achieving long-term economic stability requires building strong financial institutions, ensuring social justice, and establishing a reliable legal system. Only then can a country shift from relying on short-term financial fixes to becoming a truly self-sufficient and developed economy.
Countries that consistently run trade deficits and experience political instability often have highly volatile exchange rates. For businesses, this means uncertainty. The biggest driver of these currency fluctuations is short-term capital flows – money that moves in and out of the country based on interest rate differences. These flows are not stable investments; they are highly reactive and can change direction rapidly, increasing exchange rate volatility. While no country prefers this kind of instability, it is unavoidable for those that rely heavily on foreign capital due to ongoing trade deficits. The only real solution is to move to a stronger economic position where the country no longer depends on these short-term inflows.
Another factor influencing exchange rates is Foreign Direct Investment (FDI). Unlike short-term speculative investments, FDI involves long-term commitments, such as building factories or infrastructure. Because these investments are planned and take time to develop, they do not cause the same level of volatility in currency markets. Countries that attract more FDI create a more stable financial environment. However, becoming a preferred destination for long-term investment requires deeper economic and institutional reforms. As discussed throughout this book, economic success is not just about financial policies – it is also about building democratic institutions, legal stability, and social trust, which have taken centuries to develop in advanced economies.
There are two key players in managing exchange rate stability. The first is an independent central bank that can set interest rates without political interference. If a central bank makes the right decisions, holds sufficient foreign currency reserves, and adjusts interest rates at the right time, it can help stabilise exchange rates. However, a central bank alone cannot solve deeper, structural problems like chronic trade deficits.
The responsibility for long-term solutions falls on policymakers, on governments and parliaments. It is their job to implement the structural changes needed to shift a country’s economic standing. If a country wants to break free from exchange rate instability, it must adopt the values and systems that underpin developed economies, such as legal security, strong institutions, and transparent governance. These reforms lead to more sustainable economic success rather than relying on short-term financial fixes.
