An exchange rate is simply the price of one currency in terms of another. For example, £1 = €1.18 tells you that if you hand over one British pound, you'll get 1.18 euros back.

Here's the mental shift that makes this topic click: stop thinking of currency as "money" and start thinking of it as a product being bought and sold. Just like the market for coffee or trainers, the market for pounds (or dollars, or euros) has a demand curve and a supply curve, and where they cross gives you the price — except here, the "price" is the exchange rate, and the "product" is the currency itself.

• If more people want to buy pounds (demand for £ increases), the price of £ goes up — it becomes worth more.
• If more people want to sell pounds (supply of £ increases), the price of £ goes down — it becomes worth less.

Central banks choose which exchange rate system their country uses. This guide focuses on the floating exchange rate system, where the government does not intervene — the market (demand and supply) is left entirely to determine the price.

A classic exam question gives you an amount in one currency, an exchange rate, and asks you to work out the profit or loss after a currency movement. The trick is to work through it in careful, separate steps — never try to do it all in your head.

Worked Example (from the textbook): Marsha holds €200,000 and expects the Pound (£) to appreciate against the €. At present, £1 = €1.10.

1. Step 1 — Convert €200,000 into £: €200,000 ÷ 1.10 = £181,818.18
2. Step 2 — Apply the depreciation: The Pound then depreciates by 10% against the Euro (the opposite of what Marsha expected!). New rate: £1 = (€1.10 × 0.9) = €0.99
3. Step 3 — Convert her Pounds back to Euros at the new rate: £181,818.18 × 0.99 = €179,999.9982 ≈ €180,000
4. Step 4 — Calculate the loss: €200,000 − €180,000 = €20,000 loss

Notice the logic: Marsha bet that the Pound would strengthen, but it weakened instead — so when she converted back, she got fewer Euros than she started with. This is exactly how currency speculation can backfire.

Remember: an increase in demand for a currency pushes its exchange rate up (appreciation). Three key drivers push demand for a currency higher:

Relative Interest Rates

Interest rates influence something called "hot money" — large flows of short-term financial capital that move between countries purely chasing the best return. If a central bank raises interest rates, savings accounts and bonds in that country suddenly pay more, so foreign investors want to move their money there to earn that higher return. To do that, they first need to buy that country's currency — so demand for the currency rises, and it appreciates.

Speculation

The vast majority of all currency trading isn't people buying holiday money — it's speculators betting on future price movements. If traders expect a currency to rise in value soon, they buy it now (increasing demand) so they can sell it later at a profit. This expectation alone is enough to cause the appreciation they were predicting — a kind of self-fulfilling prophecy.

Demand for Exports

If foreign buyers want to purchase more of a country's exports (say, more people abroad want to buy British-made goods), they first need to exchange their own currency into Pounds to pay for them. This directly increases the demand for the Pound on FOREX, pushing its value up.

Now flip it around. An increase in the supply of a currency pushes its exchange rate down (depreciation). The same three forces work in reverse:

Relative Interest Rates in Foreign Countries

If a country's interest rate falls relative to others, investors holding that currency will sell it (supplying it to the market) in favour of currencies elsewhere that now offer better returns. More sellers = more supply = the currency depreciates.

Speculation

If traders expect a different currency to rise in value, they'll sell (supply) their current holdings in order to buy that other currency. This increased supply causes their original currency to depreciate.

Demand for Imports

If domestic consumers want to buy more foreign goods (imports), they need to exchange their own currency for foreign currency to pay for them. This increases the supply of their own currency onto the FOREX market, causing it to depreciate.

Appreciation happens in a floating exchange rate system when there is excess demand for a currency on FOREX — the price of that currency rises, meaning it becomes worth more / more expensive to buy. It's also called "strengthening" or "revaluation."

Impact on the Current Account

Depreciation is the mirror image of appreciation. It happens when there is excess supply of a currency on FOREX — the currency's price falls, meaning it becomes worth less / cheaper to buy. Also called "devaluation."

Impact on the Current Account