7.2.2 Currency exchange

An exchange rate tells us how much of a country’s currency is needed to buy one unit of another country’s currency. It is the price of one country’s currency measured in another country’s currency. 

This may be confusing at first, because we are used to prices measuring the value of goods or services. With exchange rates, the ‘good’ being bought and sold is another currency. One currency is the product, and the other currency is the money used to pay for it.

Consider the currencies of India and Sri Lanka on 5 March 2022, before the sharp fall in the Sri Lankan rupee. On that date, the exchange rate was:

1 Indian rupee = 2.7 Sri Lankan rupees

This means that the price of one Indian rupee was 2.7 Sri Lankan rupees. If someone in Sri Lanka wanted to buy 100 Indian rupees, they would need 270 Sri Lankan rupees. The same relationship can be described from the opposite direction:

1 Sri Lankan rupee = 0.37 Indian rupees

This means that the price of one Sri Lankan rupee was 0.37 Indian rupees. If someone in India wanted to buy 100 Sri Lankan rupees, they would need 37 Indian rupees. These two prices describe exactly the same exchange rate, just from opposite perspectives. One tells us the price of the Indian rupee. The other tells us the price of the Sri Lankan rupee.

For any two currencies, the exchange rates are reciprocals of each other. The rule is:

Reciprocal exchange rate = 1 ÷ original exchange rate

So if the the original exchange rate was expressed as:

1 Indian rupee = 2.7 Sri Lankan rupees

Then the reciprocal exchange rate would be expressed as:

1 Sri Lankan rupee = 1 ÷ 2.7 Indian rupees ≈ 0.37 Indian rupees

Exchange rates over time

So far, we have looked at exchange rates at a single point in time. To understand what happened in Sri Lanka in 2022, we now need to look at how exchange rates change over time.

The two graphs show the exchange rate between the Indian rupee and the Sri Lankan rupee over many years. Focus on the period between March and June 2022.

Figure 2 shows how many Sri Lankan rupees it takes to buy one Indian rupee, which increased from about 2.7 to 4.6 during the time period. It took more Sri Lankan rupees than before to buy one Indian rupee.

Figure 3 shows the same change from the opposite direction, how many Indian rupees it takes to buy one Sri Lankan rupee. Over the same period, it takes fewer Indian rupees, from 0.37 to 0.22 to buy one Sri Lankan rupee.

Both graphs show the same event, but the graph in Figure 3 is the reciprocal of the graph in Figure 2. 

Figure 2 shows the price of the Indian rupee rising in terms of Sri Lankan rupees. Figure 3 shows the price of the Sri Lankan rupee falling in terms of Indian rupees. 

When a currency rises in value against another, as was the case for the Indian rupee, we say it has appreciated. When a currency declines in value against another, as was the case for the Sri Lankan rupee, we say it has depreciated.

Currencies are traded in global markets and the exchange rate is the price of a currency. Like other markets, prices are affected by demand and supply. All other things being equal, when demand for a currency rises, its price rises in a positive or direct relationship. When supply rises, its price falls (Figure 4) in an inverse relationship (Section 3.1.2). The price of a currency, in turn, feeds back to impact demand and supply in a balancing feedback loop (Section S.5).

Demand and supply for currencies come from many different sources, and they do not all operate at the same speed or scale. These would be factors that would cause demand or supply to increase or decrease, which in turn would impact the price of the currency.

Slow pressures from trade and inflation

Trade and inflation pressures on demand and supply of currencies tend to build up gradually over time.

Consider Switzerland, which uses the Swiss franc, and Germany, which uses the euro. When Swiss consumers buy more products from Germany, they need euros to pay for them. This increases demand for euros. At the same time, to purchase those euros, Swiss consumers have to sell Swiss francs, increasing the supply of francs on foreign exchange markets. The increase in demand for euros pushes up the price of the euro (appreciation), and increased supply of Swiss francs pushes down the price of the franc (depreciation), seen in the markets for the two currencies in Figure 5.

Inflation also matters. Inflation is a rise in the general price level in an economy (Section 5.3.6). If prices rise faster in Germany than in Switzerland, German goods become less competitive relative to Swiss goods. Over time, this reduces Swiss demand for German exports, which means less demand for euros on foreign exchange markets. This puts downward pressure on the value of the euro, but slowly, over months or even years as consumers adjust to the inflation.

Fast pressures from finance, expectations, and interest rates

Other pressures act much more quickly. Today, most currency trading is not from firms paying for imports or receiving payments for exports. Instead, it is driven by banks and individuals buying and selling currencies in very large volumes. Central bank studies show that the vast majority of foreign exchange transactions are financial rather than trade-related.

These trades are based on expectations about the future. Banks and individuals move money in response to changes in interest rates, political events, economic news, and fears about economic stability in a country. Many currency trades are made for speculation, aiming to profit from price changes. Because these decisions can be made in seconds, exchange rates often move before anything in the real economy has changed.

Interest rates play a key role. If the Swiss National Bank raises interest rates while eurozone rates stay the same, Swiss financial assets become more attractive to people and businesses seeking higher returns. To get those returns, they need to buy Swiss francs, increasing demand for the franc and pushing up its value against the euro. On the other hand, if Swiss interest rates decline, the opposite can happen. People and businesses may sell their Swiss francs to buy other currencies, increasing the supply of francs on currency markets, and causing the franc to depreciate.

When a currency changes value, the effects are uneven. A weaker currency helps exporters by making their goods cheaper for foreign buyers so they may be able to sell more. But a weaker currency raises the cost of imports for households and firms, increasing inflation. This is most felt by countries that have to import essentials like food, fuel or medicine. When debts are owed in a foreign currency, as was the case for Sri Lanka, a fall in the local currency increases the real burden of repayment. 

On the other hand, a stronger currency makes imports cheaper and can reduce inflation, but makes exports less competitive and puts pressure on jobs in export industries. 

There is no single exchange rate that benefits everyone. Exchange rate movements redistribute costs and benefits across society, depending on who earns, spends, saves, or borrows in which currency.

Exchange rates are not left entirely to market forces of supply and demand. Central banks and states sometimes intervene when movements risk destabilising the wider economy. They may also try to affect the value of their currency to achieve certain objectives, like weakening the exchange rate to help export industries. 

Options to manage exchange rates include:

• changing interest rates: A central bank can raise interest rates to help a currency appreciate and lower interest rates to help a currency depreciate. This mechanism was explained earlier in this section.

• buying and selling the country’s currency: Central banks hold a collection of foreign currencies — like US dollars, euros, British pounds and Japanese yen — and other assets. These are known as foreign reserves. The central bank can sell these currencies or assets to buy their own currencies, increasing demand to appreciate the currency. They can also sell their own currencies if they want to increase the supply of the currency and depreciate it.

• communication to affect expectations: When central banks signal that they will raise interest rates, defend a currency’s value, or tolerate a weaker exchange rate, markets often react immediately and bring about the change that the central bank wants. For example, if a central bank says it is prepared to sell foreign reserves to buy its own currency to uphold its value, currency speculators may stop selling the country’s currency because they have more confidence in its value remaining stable. Using communication like this to affect expectations is sometimes described as 'talking up' or 'talking down' a currency.

Floating, fixed, and managed exchange rates

In a floating exchange rate system, demand and supply in currency markets largely determine the exchange rate. This means the exchange rate can adjust freely to changes in trade, investment, and economic conditions. But it can also swing sharply in response to financial speculation or sudden shifts in investor confidence, creating uncertainty for businesses and households that depend on imports or exports. Thus, central banks often intervene in currency markets to a greater or lesser extent (Figure 7).

In a fixed exchange rate system, the value of the currency is tied to another currency at a set rate. Denmark, for example, keeps the Danish krone closely tied to the euro (Figure 8). This gives businesses and investors certainty about prices and costs across borders, which can support trade and investment between significant trading partners. Denmark and the EU are close trading partners because of Denmark’s geographic position with the rest of Europe. But note that the Danish krone floats freely against the Japanese yen, a less important trading partner.

Maintaining a fixed rate has costs. A fixed exchange rate limits how the central bank can set interest rates, since changes in interest rates affect demand for the currency and could push the exchange rate away from its fixed level. Also, if for some reason demand for the currency falls or supply increases and the exchange rate depreciates, the central bank must buy its own currency with its foreign currency reserves, artificially keeping demand high to keep the exchange rate stable.

This is what happened to Sri Lanka. Before 2022, the central bank kept the rupee close to a fixed rate against the US dollar (which also stabilised it against the Indian rupee). The Sri Lankan central bank used its US dollar reserves to buy Sri Lankan rupees. As tourism and export earnings fell and debts grew, that became harder to sustain as people lost confidence in the Sri Lankan economy. Tourism and exports are major sources of the foreign currency Sri Lanka needs to keep its reserves topped up. In March 2022, with its foreign currency reserves nearly gone, the central bank gave up and let the Sri Lankan rupee float freely on currency markets. The pressure that had built up for months hit the market all at once, and the rupee lost over 40 percent of its value against the dollar within weeks.

Managed exchange rates

A managed exchange rate system sits between these two. The exchange rate is allowed to move, but the central bank intervenes at times to slow sharp swings or push back against speculative pressure. Many countries use this approach, accepting some exchange rate movement while trying to prevent the kind of rapid, destabilising shifts that Sri Lanka experienced in 2022.

Concept: Systems

Skills: Thinking skills (transfer)

Time: varies, depending on option

Type: Individual, pairs, or small groups

Option 1: Factors affecting exchange rates

Time: 15 minutes

For each situation below, decide whether the described change is likely to cause the currency named to appreciate or depreciate, all other things being equal. Write a sentence explaining your reasoning in terms of demand and supply.

1. Germany's exports to the United States increase significantly. Will the euro appreciate or depreciate against the dollar?

2. Inflation in Brazil rises much faster than in its main trading partners. Will the Brazilian real appreciate or depreciate?

3. The Bank of England raises interest rates while other central banks hold rates steady. Will the pound appreciate or depreciate?

4. People and businesses lose confidence in a state's ability to manage its debts and begin moving money out of the country. Will that country's currency appreciate or depreciate?

5. A country's tourism industry collapses following a natural disaster, removing a major source of foreign currency earnings. Will that country's currency appreciate or depreciate?

6. The European Central Bank announces it will cut interest rates. Will the euro appreciate or depreciate?

Why did the dollar weaken?

The tariffs announced in 2025 were unusually broad, covering imports from nearly all of the United States' trading partners. Many of those partners responded with their own tariffs on US goods. This retaliation would reduce demand for US exports and therefore demand for dollars from abroad. Investors began to worry that the combination of tariffs and counter-tariffs would slow economic growth in the US economy. Worries about recession caused some people and businesses to move money out of dollar assets and into other currencies and markets. They had to sell US dollars to do this, increasing the supply of US dollars in currency markets and pushing the value of the US dollar down. The dollar fell over 9 percent against a basket of currencies in 2025, its worst performance since 2017.

Why did the Mexican peso hold up?

On the Mexican side, several factors supported the price peso relative to the US dollar. Mexico's central bank, Banco de México, kept its interest rate well above that of the United States throughout 2025, ending the year at 7 percent compared to the US rate of 3.5 to 3.75 percent. This interest rate difference made Mexican financial assets more attractive to international investors, increasing demand for pesos.

Foreign investment into Mexico also reached a record high in 2025, driven in part by nearshoring, where companies move production to Mexico to be closer to the large US market. Mexico received a record US$40.9 billion in foreign direct investment in the first nine months of 2025, an increase of 14.5 percent compared to the same period of 2024. These investment flows required investors to buy pesos, adding further demand for the currency.

The overall outcome was that the dollar weakened broadly, while the peso was supported by its own strengths. The exchange rate between the two reflected both forces acting at the same time.

Questions to consider:

1. On 8 February 2025, one US dollar cost 20.56 Mexican pesos. On 8 February 2026, one US dollar cost 17.14 Mexican pesos. Calculate the percentage change in the number of pesos needed to buy one dollar. Has the peso appreciated or depreciated against the dollar?

2. Using the reciprocal rule, calculate the exchange rate from the opposite direction: how many dollars did one peso buy on 8 February 2025, and how many on 8 February 2026?

3. Identify one slow-moving and one fast-moving pressure that influenced the exchange rate between the dollar and the peso during this period.

4. Consider the following groups: a Mexican worker whose wages are paid in pesos, a Mexican business that imports equipment priced in US dollars, a Mexican business exporting goods to the United States, a US tourist visiting Mexico, and a US company buying Mexican-made equipment. For each group, explain whether the peso's appreciation helped or hurt them, and why.

5. The case study shows that a currency's value can change because of what is happening to the other currency in the pair, not just conditions in its own country. Why does this make interpreting exchange rate movements more complicated than the approach used in Option 1?

Option 3: Case study: The Swiss franc shock

Time: 30–40 minutes

(Note: some questions in this activity relate to feedback loops, covered in Section S.5. Students who have not yet studied that section may skip those questions or use the case study for a different activity.)

On the morning of 15 January 2015, the Swiss National Bank (SNB) made an announcement that stunned financial markets. Without warning, it abandoned the fixed exchange rate it had maintained between the Swiss franc and the euro for more than three years.

Background

In 2011, there were serious economic problems across the eurozone. Many people and businesses responded by moving money out of euros and into the Swiss franc, which they considered a safe and stable currency. Demand for francs rose sharply, and the franc appreciated strongly against the euro. This was a serious problem for Switzerland: around 70 percent of Swiss GDP comes from exports, and a stronger franc made Swiss goods more expensive for foreign buyers, threatening Swiss businesses and jobs.

To stop the appreciation, the SNB introduced a managed exchange rate, committing to keep the franc at no lower than 1.20 francs per euro, called a currency peg. To hold the rate there, the SNB had to buy large quantities of euros whenever demand for francs threatened to push the rate below 1.20. Over three years, it accumulated foreign currency reserves worth around 480 billion dollars, equivalent to roughly 70 percent of Switzerland's entire annual economic output.

By late 2014, the European Central Bank (ECB) was preparing to launch a major programme of quantitative easing, creating new money to buy government bonds across the eurozone. This was expected to weaken the euro significantly. If the euro fell further, the SNB would need to buy even more euros to maintain the managed exchange rate, potentially without limit. On 15 January 2015, the SNB decided this was no longer sustainable. It abandoned the currency peg.

What happened next

Within minutes, the franc appreciated by around 30 percent against the euro before settling at around 20 percent above its previous level. The Swiss stock market fell more than 10 percent in a single day. Swiss export companies faced immediate pressure, since their goods had suddenly become much more expensive for foreign buyers. Tourism businesses feared a sharp drop in visitors. The SNB simultaneously cut its interest rate to minus 0.75 percent, a negative rate, to make holding francs in Swiss banks less attractive and reduce some of the demand for the currency. A negative interest rate means that people have to pay Swiss banks to hold money in accounts there, when usually the bank pays interest to depositors.

Questions to consider:

1. Identify the feedback loop that was driving franc appreciation in 2011. Draw it as a causal loop diagram, showing whether each relationship is direct/positive (moving in the same direction, +) or indirect/negative (moving in opposite directions, −).

2. The SNB decided it needed to intervene by introducing a currency peg.

1. Explain why a rising franc was a problem for Switzerland and why market forces were unlikely to correct the appreciation on their own.

2. Define a currency peg and explain how it should work.

3. What changed in late 2014 and early 2015 that made the peg unsustainable?

4. The SNB cut interest rates to minus 0.75 percent at the same time as abandoning the peg. Explain why negative interest rates might help reduce upward pressure on the franc.

5. Consider who gained and who lost from the franc's sudden appreciation in January 2015.

Ideas for longer activities and projects are listed in Subtopic 7.5

Tutor2u has two useful videos on exchange rates:

• Exchange Rates - An Introduction - a nine minute video explaining exchange rate basics. Difficulty level: easy

• Exchange Rates Explained - a nine minute video explaining the factors affecting the value of currencies over time. Difficulty level: easy

The CORE Econ Team. (2023). Exchange rate regimes, monetary policy, and inflation. In Unit 7: Macroeconomic policy in the global economy. The Economy 2.0: Macroeconomics (Open access e-text). https://books.core-econ.org/the-economy/macroeconomics/07-macroeconomic-policy-global-economy-02-exchange-rate-regimes-monetary-policy-inflation.html

The CORE Econ Team. (2023). Monetary policy and the exchange rate. In Unit 5: Macroeconomic policy. The Economy 2.0: Macroeconomics (Open access e-text). https://books.core-econ.org/the-economy/macroeconomics/05-macroeconomic-policy-14-exchange-rate.html

FXStreet. (2025, December 24). USD/MXN Price Annual Forecast: Peso poised for a volatile 2026 after stellar 2025 rally https://www.fxstreet.com/analysis/usd-mxn-price-annual-forecast-peso-poised-for-a-volatile-2026-after-stellar-2025-rally-202512241829

Kognity. (n.d.). 4.5 Exchange rates. IBDP Economics HL FE2024

Mexico News Daily. (2025, December 31). Mexico's year in review: The 10 biggest business and economics stories of 2025. https://mexiconewsdaily.com/business/10-biggest-business-and-economics-stories-of-2025-for-end-of-year/

Pound, Jesse. (2025, April 6). Trump's tariffs were expected to boost the dollar, but recession fears are dragging it down. CNBC. https://www.cnbc.com/2025/04/06/trumps-tariffs-were-expected-to-boost-the-dollar-but-theyre-not.html

Rascoe, Ayesha. (2026, January 4). Why the dollar fell over 9% in 2025, and what to expect in 2026. NPR. https://www.npr.org/2026/01/04/nx-s1-5662540/why-the-dollar-fell-over-9-in-2025-and-what-to-expect-in-2026

Samarakoon, L. P. (2023). What broke the pearl of the Indian ocean? The causes of the Sri Lankan economic crisis and its policy implications. World Development, 172, 106364. https://www.sciencedirect.com/science/article/abs/pii/S1572308923001134

United Nations Office of the High Commissioner for Human Rights. (2022, July 20). Sri Lanka: UN experts sound alarm on economic crisis. https://www.ohchr.org/en/press-releases/2022/07/sri-lanka-un-experts-sound-alarm-economic-crisis

Yale Budget Lab. (2025). Tariffs, the dollar, and the Fed. https://budgetlab.yale.edu/research/tariffs-dollar-and-fed

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