Currency and Exchange Rates

Every international transaction involves currency exchange. When a German company buys American software, euros must be converted to dollars. When a Japanese tourist visits France, yen must become euros. The exchange rate is the price of one currency in terms of another.

Exchange Rate Systems

Floating exchange rate — The market determines the rate based on supply and demand. Most major currencies (USD, EUR, GBP, JPY) float.

Fixed/pegged exchange rate — The government sets the rate and intervenes to maintain it. Saudi Arabia pegs the riyal to the dollar. Hong Kong pegs its dollar to the US dollar.

Managed float — The currency mostly floats, but the government intervenes to prevent extreme movements. China's yuan operates this way.

What Moves Exchange Rates?

• Interest rates — Higher rates attract foreign investment, strengthening the currency
• Inflation — High inflation weakens a currency (your money buys less)
• Trade balances — Countries that export more than they import see demand for their currency rise
• Political stability — Uncertainty weakens currencies (the pound fell 25% after the Brexit vote)
• Speculation — Currency traders move trillions daily, amplifying movements

The Dollar's Dominance

The US dollar is the world's reserve currency — the currency other countries hold in their central banks and use for international transactions:

• ~58% of global foreign exchange reserves are in dollars (down from 71% in 2000)
• ~88% of foreign exchange transactions involve the dollar
• Oil is priced in dollars ("petrodollar" system)
• Most international debt is denominated in dollars

This gives the US an "exorbitant privilege" (as France's Valery Giscard d'Estaing called it):

• The US can borrow cheaply because everyone wants dollars
• The US can fund massive trade deficits because dollars always come back as investment
• The US can weaponize the dollar through sanctions

De-dollarization

Countries increasingly want alternatives:

• China promotes yuan-denominated trade (oil deals with Saudi Arabia, trade with Russia)
• BRICS members discuss a shared settlement currency
• Central Bank Digital Currencies (CBDCs) could enable direct bilateral settlement

But the dollar's dominance has deep structural roots — no alternative currently offers the liquidity, stability, and legal infrastructure of US financial markets.

Worked Example: How a Weaker Currency Boosts Exports

A Japanese carmaker sells a vehicle for ¥3,000,000. Its US price depends entirely on the exchange rate.

When the yen depreciates from 100 to 150 per dollar, the same car — with no change in Japanese costs — becomes $10,000 cheaper in the US, boosting Japanese exports. A stronger yen does the opposite. This is why governments are tempted by competitive devaluation, and why a country's export competitiveness can swing sharply without any change in productivity. It also shows the flip side: a weaker currency makes imports (and imported oil) more expensive at home, feeding inflation.