International currencies are a tricky business, but basic economic principles hold internationally as well as nationally. Contrary to the statements of many politicians, trade deficits are not necessarily a problem, unless a country is investing foolishly or not saving enough. In either case, the trade deficit is not the root of the relevant problem. Instead of complaining about America’s current trade deficit with China, it is better to consider how the United States might save more. The trade balance is simply one side of the coin, with the capital account serving as the other side. If a lot of capital is flowing into a country, that country also will be running a trade deficit.

Exchange rates are set in active markets, changing by the second every day, and following the laws of supply and demand. Monetary policy can affect real exchange rates in the short run, but not in the long run. In the long run, exchanges rates are set according to purchasing power parity, so that profits cannot be made buying goods in one country and shipping them to another.

Both monetary and fiscal policies will affect a country’s real exchange rate in the short run and these exchange rate effects will influence aggregate demand by affecting some mix of exports, imports, and the flow of capital from one country to another.

Most countries today have floating exchange rates with values determined in international currency markets. Fixed or pegged exchange rates are possible but in most circumstances they are difficult to maintain over the longer run. Thus, a combination of currency unions and floating exchange rates has increasingly become the global norm.

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The IMF and The World Bank may inspire protests but for good or ill these institutions are modestly sized bureaucracies in a much larger globalized world.