An exchange rate is the price of one currency expressed in another currency. It determines how amounts of money are converted across monetary systems and influences the prices of internationally traded goods, services, and financial assets. Exchange rates are central to international trade and macroeconomics because their movements affect purchasing power, inflation, and cross-border financial flows. They may be determined principally by markets or maintained through official arrangements. (rba.gov.au)
Quotation and currency movements
A bilateral exchange rate compares two currencies. A hypothetical quotation of USD 1.20 per euro means that one euro buys 1.20 US dollars; its reciprocal is approximately EUR 0.8333 per dollar. The direction of quotation matters: an increase in dollars per euro indicates a stronger euro, whereas an increase in euros per dollar indicates a stronger dollar. A cross rate is calculated from two exchange rates sharing a third currency, provided their quotations are consistent. (rba.gov.au)
Appreciation means that a currency gains value relative to another; depreciation means that it loses value. These describe relative movements rather than changes in domestic purchasing power. Under an officially maintained parity, a downward adjustment is generally called devaluation, and an upward adjustment revaluation. A currency can appreciate against one currency while depreciating against another, so a single bilateral quotation does not establish its overall strength. (rba.gov.au)
Nominal, real, and effective rates
A nominal exchange rate compares currency units without adjusting for prices. A real exchange rate incorporates relative price levels. If denotes domestic currency units per foreign currency unit, the foreign price level, and the domestic price level, a common definition is:
Under this convention, an increase in represents real depreciation: foreign goods become more expensive relative to domestic goods. Price measures such as the consumer price index can be used to construct these comparisons. Other conventions invert the ratio, so the meaning of an increase must always be specified. (imf.org)
An effective exchange rate measures a currency against a weighted basket of currencies. Trade-weighted indices commonly assign weights according to trading-partner importance, while more elaborate measures account for competition in third-country markets. A real effective rate additionally adjusts for relative prices or costs. These indices describe changes from a reference period; their numerical level alone does not prove that a currency is overvalued or undervalued. (rba.gov.au)
Exchange-rate arrangements
Under a floating exchange rate, supply and demand in the foreign exchange market principally determine the currency’s value. A central bank may nevertheless intervene during disorderly conditions or to moderate volatility. A fixed exchange rate, or peg, ties the currency to another currency or basket, sometimes within a permitted band. Intermediate arrangements include managed floating and crawling pegs, whose reference value is adjusted over time. (rba.gov.au)
Maintaining a peg can require purchases or sales of currencies using foreign exchange reserves. It also constrains independent monetary policy. The impossible trinity describes the incompatibility of simultaneously maintaining a fixed exchange rate, unrestricted international capital movement, and fully independent monetary policy. Actual arrangements vary in how much exchange-rate flexibility or capital mobility they permit. (rba.gov.au)
Determinants and theoretical relationships
Exchange-rate movements reflect trade payments, investment flows, and expectations about future economic conditions. Differences in interest rates influence the relative attractiveness of currency-denominated assets: other things equal, higher domestic rates can support a currency. For commodity-exporting economies, changes in the terms of trade—export prices relative to import prices—can also be important. News and changes in investor risk appetite may produce rapid movements in financial markets. No single factor explains every movement. (rba.gov.au)
Purchasing power parity relates exchange rates to the cost of comparable baskets of goods and services. Relative purchasing power parity associates differences in inflation with longer-term currency adjustments. It is not a precise short-term forecasting rule: transport costs, trade barriers, nontraded services, and differences in productivity can sustain substantial departures from simple price equalization. Purchasing-power-parity conversion rates used for international economic comparisons need not match market exchange rates. (rba.gov.au)
Spot and forward exchange
A spot exchange rate applies to a transaction for near-term settlement. A forward exchange rate is agreed now for a currency exchange on a specified future date. Forward contracts allow participants to hedge exchange-rate exposure rather than leave the future conversion price uncertain. The forward rate is a contractual price, not necessarily an accurate forecast of the future spot rate. (bis.org)
Covered interest parity links spot rates, forward rates, and interest rates through arbitrage. In an idealized setting, comparable investments should yield equal returns when currency exposure is covered with a forward contract. Forward premiums or discounts therefore reflect interest-rate differentials. In practice, funding conditions, hedging demand, and constraints on banks’ balance sheets can generate persistent deviations from this relationship. (bis.org)
Economic effects
Depreciation generally raises domestic-currency import prices and can make domestic production more competitive internationally; appreciation tends to work in the opposite direction. Effects on output and inflation depend on firms’ pricing decisions, demand responses, imported production inputs, and adjustment lags. Currency movements also change the domestic value of foreign-currency assets and liabilities: depreciation increases the burden of unhedged foreign-currency debt while increasing the domestic value of foreign-currency assets. (rba.gov.au)