Exchange Rates Explained: How Currencies Are Valued in an Open Economy
- ▸An exchange rate is the price of one currency in another, driven by trade and capital flows; countries choose between floating, fixed and managed regimes.
- ▸The Swiss franc floor of 2011–2015 and sterling's fall after the 2016 referendum show the trilemma at work: a fixed rate with free capital had to be abandoned, and a floating rate passed the shock into inflation.
- ▸Purchasing power parity anchors exchange rates in the long run and interest parity in the short run, though both hold only loosely in the data.
Understanding exchange rates — simply put
An exchange rate is the price of one currency in terms of another: how many dollars one euro buys, or how many yen one dollar buys. Like any price, it moves with supply and demand. Demand for a currency comes from foreigners buying a country's exports, assets and bonds; supply comes from residents buying foreign goods and assets. When money flows in, the currency rises; when it flows out, the currency falls.
Countries choose how much to let that price move. Under a floating rate, as in the euro area, the United States, the United Kingdom and Japan, the market sets the rate and the central bank rarely intervenes. Under a fixed rate or peg, the central bank holds the rate at a chosen level by buying and selling its own currency. Hong Kong, for example, has kept its dollar within a band of 7.75 to 7.85 per U.S. dollar since 2005.
How does it actually help?
Take a basket of goods that costs €100 in the euro area and $115 in the United States. If prices alone set the rate, one euro should buy $1.15; that is the purchasing power parity (PPP) rate, defined as the ratio of the two price levels, P_US / P_EA = 115 / 100. If the market rate is actually $1.08 per euro, the euro buys less in the United States than at home. By the PPP yardstick the euro is undervalued by 1.08 / 1.15 − 1 ≈ −6.1%, which makes euro area exports cheap for American buyers.
Why does this matter?
The exchange rate reaches almost every part of the economy. A weaker currency makes exports cheaper and imports dearer, which supports exporters but raises the price of imported fuel, food and inputs, feeding inflation. It changes the burden of debts owed in foreign currency, the returns foreign investors earn and the room central banks have to set interest rates. For a household it shows up in the cost of imported goods and holidays; for a government it can decide whether a debt is affordable.
What makes a currency rise or fall?
Over days and months, interest rate differences and capital flows dominate: money moves toward currencies offering higher expected returns, adjusted for risk. Over a few years, trade balances and relative inflation matter more. Over the long run, prices pull exchange rates toward PPP, though slowly. Surprises, from elections to central bank decisions, can move a currency more in an hour than fundamentals do in a year.
The takeaway
An exchange rate is a price set by flows of trade and capital, and every country has to decide how much to let it move. The rest of this piece works through two real episodes, the trade-offs behind each choice of regime, and the formulas that link exchange rates to interest rates and prices.
A worked example: two European currency shocks
Switzerland's minimum exchange rate, 2011–2015
During the euro area debt crisis, investors poured money into the Swiss franc as a safe haven, pushing it up so fast that Swiss exporters and the economy were at risk of deflation. On 6 September 2011 the Swiss National Bank (SNB) set a minimum exchange rate of 1.20 francs per euro and promised to buy unlimited amounts of foreign currency to defend it. For more than three years the floor held.
Holding it meant creating francs and buying euros on a massive scale, and the SNB's balance sheet ballooned. When markets expected further easing by the European Central Bank, which would have weakened the euro and required even larger purchases, the SNB judged the floor unsustainable. On 15 January 2015 it abandoned the minimum rate and cut the interest rate on sight deposits from −0.25% to −0.75%. The franc jumped and briefly traded stronger than one franc per euro.
Sterling and the 2016 referendum
On the night of 23 June 2016 the pound was trading near $1.50 as early polls pointed to a vote to remain in the European Union. As results showed a vote to leave, it fell more than 10% to a low of $1.3236 on 24 June, its weakest level since 1985. The fall fed through to prices over the following year: UK consumer price inflation rose from 0.5% in June 2016 to 3.1% in November 2017, well above the Bank of England's 2% target, and the Bank attributed most of the overshoot to the weaker pound.
| Date | Event | Exchange rate |
|---|---|---|
| 6 Sep 2011 | SNB sets minimum rate | 1.20 CHF per EUR floor |
| 15 Jan 2015 | SNB abandons minimum rate; deposit rate cut to −0.75% | Franc briefly stronger than 1.00 CHF per EUR |
| 23 Jun 2016 | UK votes in EU referendum | About $1.50 per GBP late in the evening |
| 24 Jun 2016 | Result confirmed | Low of $1.3236 per GBP |
The two episodes show both sides of the same trade-off. Switzerland tried to fix its exchange rate while keeping capital fully mobile, and in the end had to give the peg up. The United Kingdom let sterling float, which absorbed the shock instantly but passed it through to import prices and inflation.
The trilemma: the conditions every regime has to accept
The Mundell-Fleming model, developed by Robert Mundell and Marcus Fleming in the early 1960s, implies that a country can have at most two of three things: a fixed exchange rate, free movement of capital, and a monetary policy set for domestic conditions. Each country's regime is a choice of which one to give up.
| Example | Fixed exchange rate | Free capital movement | Independent monetary policy |
|---|---|---|---|
| United States / euro area | No | Yes | Yes |
| Hong Kong (U.S. dollar peg) | Yes | Yes | No |
| Switzerland 2011–2015 (floor) | Yes (one-sided) | Yes | Limited |
| Countries with capital controls | Managed | No | Yes |
- Free capital plus a fixed rate means interest rates must follow the anchor country. Hong Kong's rates track U.S. rates because any gap would pull money in or out until the peg broke.
- Free capital plus independent policy means the exchange rate must float. The Federal Reserve and the European Central Bank set rates for their own economies and let the dollar and euro move.
- A fixed rate plus independent policy requires restrictions on capital flows, so that interest rate gaps do not trigger flows that overwhelm the peg.
The formula
Readers who only need the intuition can skip this section. Four relationships underpin most exchange rate analysis. Here e is the nominal exchange rate in units of domestic currency per unit of foreign currency, so a rise in e is a depreciation of the domestic currency.
| Pass-through share φ | Import share of basket | Effect on price level (%) |
|---|---|---|
| 0.2 | 0.3 | 0.9 |
| 0.4 | 0.3 | 1.8 |
| 0.6 | 0.3 | 2.7 |
| 0.6 | 0.5 | 4.5 |
Uncovered interest parity performs poorly over short horizons: high-interest currencies often keep appreciating instead of falling, the pattern behind carry trades and known as the forward premium puzzle. PPP holds only over long periods, and deviations typically shrink by about half only after several years. Both are better treated as long-run anchors than as forecasting rules.
When these models aren't the right tool
- Short-term forecasting. Exchange rates over weeks and months are close to unpredictable; a simple random walk has long been hard to beat. Fundamentals explain direction over years, not days.
- Crisis dynamics. Sudden stops in capital flows, speculative attacks on pegs and safe-haven surges, like the Swiss franc in 2011, are driven by expectations and balance sheets that the simple parity conditions leave out.
- Non-traded goods. PPP compares baskets that include rents, haircuts and other services that cannot be traded across borders. Richer countries have higher prices for these, so their currencies look persistently "overvalued" by PPP. That is the Balassa-Samuelson effect, not a mispricing.
The takeaway
Exchange rates are prices set by trade and capital flows, anchored in the long run by prices and in the short run by interest rates, and every regime has to give up one corner of the trilemma. How currencies interact with monetary policy, inflation and the business cycle follows from those relationships.
Further reading
- Monetary Policy Explained — internal
- Understanding Inflation — internal
- Supply and Demand Explained — internal
- Fiscal Policy and Multipliers Explained — internal
- Thomas Jordan: The SNB's monetary policy after the discontinuation of the minimum exchange rate (BIS) — external reference
- Bank of England: monetary policy — external reference
Data note: the Swiss dates and deposit-rate change are from the Swiss National Bank as published by the BIS; the sterling low is the market level reported on 24 June 2016; UK inflation figures are from the Office for National Statistics. The PPP, interest parity and pass-through examples use illustrative inputs. A live chart of GBP/USD (FRED series DEXUSUK) can be added once that series is set up as an indicator.
Frequently Asked Questions
What is an exchange rate?
An exchange rate is the price of one currency in terms of another, such as the number of U.S. dollars one euro buys. It is set by supply and demand for each currency, driven by trade, investment flows, interest rates and expectations, unless a central bank fixes it.
What determines exchange rates?
In the short run, interest rate differences, capital flows and news about policy or politics move exchange rates most. Over several years, trade balances and relative inflation matter more. In the long run, exchange rates tend toward purchasing power parity, where the same basket of goods costs the same in a common currency.
What is the difference between a fixed and a floating exchange rate?
A floating exchange rate is set by the market, with little central bank intervention, as with the euro, the U.S. dollar and the pound. A fixed exchange rate is held at a set level against another currency by a central bank that buys and sells its own currency, as Hong Kong does against the U.S. dollar.
What is the impossible trinity?
The impossible trinity, or trilemma, says a country cannot have a fixed exchange rate, free capital movement and an independent monetary policy at the same time. It can choose only two. The idea comes from the Mundell-Fleming model of open-economy macroeconomics.
What is purchasing power parity?
Purchasing power parity (PPP) is the exchange rate at which the same basket of goods costs the same in two countries. If a basket costs €100 in the euro area and $115 in the United States, the PPP rate is $1.15 per euro. PPP is a long-run anchor; market rates can differ from it for years.
What is the real exchange rate?
The real exchange rate adjusts the nominal exchange rate for differences in price levels between countries. It measures how expensive one country's goods are relative to another's in a common currency, so it captures competitiveness better than the nominal rate.
Why did the Swiss National Bank remove the franc's floor in 2015?
The SNB introduced a minimum rate of 1.20 francs per euro in September 2011 and removed it on 15 January 2015. Defending the floor required ever-larger purchases of foreign currency, and expected easing by the European Central Bank would have made those purchases larger still, so the SNB judged the floor unsustainable.
Does a weaker currency cause inflation?
A weaker currency raises the domestic price of imports, and part of that increase is passed on to consumer prices. How much depends on the import share of spending and how much firms pass on. After the 2016 referendum the pound fell sharply and UK inflation rose from 0.5% to 3.1% by November 2017.
Primary Sources
Cite This Article
EconoLens Research Desk. (2026, October 22). Exchange Rates Explained: How Currencies Are Valued in an Open Economy. EconoLens. https://www.econolens.co.in/news/study-exchange-rates-open-economy-explained
The EconoLens Research Desk reviews academic papers in economics and econometrics, translating cutting-edge research into accessible analysis. Full credit is given to original authors in every review.