We’ve just seen how differences in the supply of loanable funds from savings and the demand for loanable funds for investment spending lead to international capital flows. We’ve also learned that a country’s balance of payments on current account plus its balance of payments on financial account add to zero: a country that receives net capital inflows must run a matching current account deficit, and a country that generates net capital outflows must run a matching current account surplus.

The behavior of the financial account—reflecting inflows or outflows of capital—is best described by equilibrium in the international loanable funds market. At the same time, the balance of payments on goods and services, the main component of the current account, is determined by decisions in the international markets for goods and services. So given that the financial account reflects the movement of capital and the current account reflects the movement of goods and services, what ensures that the balance of payments really does balance? That is, what ensures that the two accounts actually offset each other?

Not surprisingly, a price is what makes these two accounts balance. Specifically, that price is the exchange rate, which is determined in the foreign exchange market.

In general, goods, services, and assets produced in a country must be paid for in that country’s currency. American products must be paid for in dollars; European products must be paid for in euros; Japanese products must be paid for in yen. Occasionally, sellers will accept payment in foreign currency, but they will then exchange that currency for domestic money.

International transactions, then, require a market—the foreign exchange market—in which currencies can be exchanged for each other. This market determines exchange rates, the prices at which currencies trade. (The foreign exchange market is, in fact, not located in any one geographic spot. Rather, it is a global electronic market that traders around the world use to buy and sell currencies.)

Table 34-3 shows exchange rates among the world’s three most important currencies as of 2 p.m., EDT, on Nov. 21, 2014. Each entry shows the price of the “row” currency in terms of the “column” currency. For example, at that time US$1 exchanged for €0.8072, so it took €0.8072 to buy US$1. Similarly, it took US$1.2388 to buy €1. These two numbers reflect the same rate of exchange between the euro and the U.S. dollar: 1/1.2388 = 0.8072.

There are two ways to write any given exchange rate. In this case, there were €0.8072 to US$1 and US$1.2388 to €1. Which is the correct way to write it? The answer is that there is no fixed rule. In most countries, people tend to express the exchange rate as the price of a dollar in domestic currency. However, this rule isn’t universal, and the U.S. dollar–euro rate is commonly quoted both ways. The important thing is to be sure you know which one you are using! See the Pitfalls on this page.

When discussing movements in exchange rates, economists use specialized terms to avoid confusion. When a currency becomes more valuable in terms of other currencies, economists say that the currency appreciates. When a currency becomes less valuable in terms of other currencies, it depreciates. Suppose, for example, that the value of €1 went from $1 to $1.25, which means that the value of US$1 went from €1 to €0.80 (because 1/1.25 = 0.80). In this case, we would say that the euro appreciated and the U.S. dollar depreciated.

Movements in exchange rates, other things equal, affect the relative prices of goods, services, and assets in different countries. Suppose, for example, that the price of an American hotel room is US$100 and the price of a French hotel room is €100. If the exchange rate is €1 = US$1, these hotel rooms have the same price. If the exchange rate is €1.25 = US$1, the French hotel room is 20% cheaper than the American hotel room. If the exchange rate is €0.80 = US$1, the French hotel room is 25% more expensive than the American hotel room.

But what determines exchange rates? Supply and demand in the foreign exchange market.

Imagine, for the sake of simplicity, that there are only two currencies in the world: U.S. dollars and euros. Europeans wanting to purchase American goods, services, and assets come to the foreign exchange market, wanting to exchange euros for U.S. dollars. That is, Europeans demand U.S. dollars from the foreign exchange market and, correspondingly, supply euros to that market. Americans wanting to buy European goods, services, and assets come to the foreign exchange market to exchange U.S. dollars for euros. That is, Americans supply U.S. dollars to the foreign exchange market and, correspondingly, demand euros from that market. (International transfers and payments of factor income also enter into the foreign exchange market, but to make things simple we’ll ignore these.)

Figure 34-5 shows how the foreign exchange market works. The quantity of dollars demanded and supplied at any given euro–U.S. dollar exchange rate is shown on the horizontal axis, and the euro–U.S. dollar exchange rate is shown on the vertical axis. The exchange rate plays the same role as the price of a good or service in an ordinary supply and demand diagram.

The figure shows two curves, the demand curve for U.S. dollars and the supply curve for U.S. dollars. The key to understanding the slopes of these curves is that the level of the exchange rate affects exports and imports. When a country’s currency appreciates (becomes more valuable), exports fall and imports rise. When a country’s currency depreciates (becomes less valuable), exports rise and imports fall.

To understand why the demand curve for U.S. dollars slopes downward, recall that the exchange rate, other things equal, determines the prices of American goods, services, and assets relative to those of European goods, services, and assets. If the U.S. dollar rises against the euro (the dollar appreciates), American products will become more expensive to Europeans relative to European products. So Europeans will buy less from the United States and will acquire fewer dollars in the foreign exchange market: the quantity of U.S. dollars demanded falls as the number of euros needed to buy a U.S. dollar rises. If the U.S. dollar falls against the euro (the dollar depreciates), American products will become relatively cheaper for Europeans. Europeans will respond by buying more from the United States and acquiring more dollars in the foreign exchange market: the quantity of U.S. dollars demanded rises as the number of euros needed to buy a U.S. dollar falls.

A similar argument explains why the supply curve of U.S. dollars in Figure 34-5 slopes upward: the more euros required to buy a U.S. dollar, the more dollars Americans will supply. Again, the reason is the effect of the exchange rate on relative prices. If the U.S. dollar rises against the euro, European products look cheaper to Americans—who will demand more of them. This will require Americans to convert more dollars into euros.

The equilibrium exchange rate is the exchange rate at which the quantity of U.S. dollars demanded in the foreign exchange market is equal to the quantity of U.S. dollars supplied. In Figure 34-5, the equilibrium is at point E, and the equilibrium exchange rate is 0.80. That is, at an exchange rate of €0.80 per US$1, the quantity of U.S. dollars supplied to the foreign exchange market is equal to the quantity of U.S. dollars demanded.

To understand the significance of the equilibrium exchange rate, it’s helpful to consider a numerical example of what equilibrium in the foreign exchange market looks like. A hypothetical example is shown in Table 34-4. The first row shows European purchases of U.S. dollars, either to buy U.S. goods and services or to buy U.S. assets. The second row shows U.S. sales of U.S. dollars, either to buy European goods and services or to buy European assets. At the equilibrium exchange rate, the total quantity of U.S. dollars Europeans want to buy is equal to the total quantity of U.S. dollars Americans want to sell.

Remember that the balance of payments accounts divide international transactions into two types. Purchases and sales of goods and services are counted in the current account. (Again, we’re leaving out transfers and factor income to keep things simple.) Purchases and sales of assets are counted in the financial account. At the equilibrium exchange rate, then, we have the situation shown in Table 34-4: the sum of the balance of payments on current account plus the balance of payments on financial account is zero.

Now let’s briefly consider how a shift in the demand for U.S. dollars affects equilibrium in the foreign exchange market. Suppose that for some reason capital flows from Europe to the United States increase—say, due to a change in the preferences of European investors. The effects are shown in Figure 34-6. The demand for U.S. dollars in the foreign exchange market increases as European investors convert euros into dollars to fund their new investments in the United States. This is shown by the shift of the demand curve from D₁ to D₂. As a result, the U.S. dollar appreciates against the euro: the number of euros per U.S. dollar at the equilibrium exchange rate rises from XR₁ to XR₂.

What are the consequences of this increased capital inflow for the balance of payments? The total quantity of U.S. dollars supplied to the foreign exchange market still must equal the total quantity of U.S. dollars demanded. So the increased capital inflow to the United States—an increase in the balance of payments on financial account—must be matched by a decline in the balance of payments on current account. What causes the balance of payments on current account to decline? The appreciation of the U.S. dollar. A rise in the number of euros per U.S. dollar leads Americans to buy more European goods and services and Europeans to buy fewer American goods and services.

Table 34-5 shows a hypothetical example of how this might work. Europeans are buying more U.S. assets, increasing the balance of payments on financial account from 0.5 to 1.0. This is offset by a reduction in European purchases of U.S. goods and services and a rise in U.S. purchases of European goods and services, both the result of the dollar’s appreciation. So any change in the U.S. balance of payments on financial account generates an equal and opposite reaction in the balance of payments on current account. Movements in the exchange rate ensure that changes in the financial account and in the current account offset each other.

Let’s briefly run this process in reverse. Suppose there is a reduction in capital flows from Europe to the United States—again due to a change in the preferences of European investors. The demand for U.S. dollars in the foreign exchange market falls, and the dollar depreciates: the number of euros per U.S. dollar at the equilibrium exchange rate falls. This leads Americans to buy fewer European products and Europeans to buy more American products. Ultimately, this generates an increase in the U.S. balance of payments on current account. So a fall in capital flows into the United States leads to a weaker dollar, which in turn generates an increase in U.S. net exports.

In 1993 one U.S. dollar exchanged, on average, for 3.1 Mexican pesos. By 2013, the peso had fallen against the dollar by more than 75%, with an average exchange rate in 2013 of 12.8 pesos per dollar. Did Mexican products also become much cheaper relative to U.S. products over that 20-year period? Did the price of Mexican products expressed in terms of U.S. dollars also fall by 75%? The answer is no, because Mexico had much higher inflation than the United States over that period. In fact, the relative price of U.S. and Mexican products changed little between 1993 and 2013, although the exchange rate changed a lot.

To take account of the effects of differences in inflation rates, economists calculate real exchange rates, exchange rates adjusted for international differences in aggregate price levels. Suppose that the exchange rate we are looking at is the number of Mexican pesos per U.S. dollar. Let P_US and P_Mex be indexes of the aggregate price levels in the United States and Mexico, respectively. Then the real exchange rate between the Mexican peso and the U.S. dollar is defined as:

To distinguish it from the real exchange rate, the exchange rate unadjusted for aggregate price levels is sometimes called the nominal exchange rate.

To understand the significance of the difference between the real and nominal exchange rates, let’s consider the following example. Suppose that the Mexican peso depreciates against the U.S. dollar, with the exchange rate going from 10 pesos per U.S. dollar to 15 pesos per U.S. dollar, a 50% change. But suppose that at the same time the price of everything in Mexico, measured in pesos, increases by 50%, so that the Mexican price index rises from 100 to 150. At the same time, suppose that there is no change in U.S. prices, so that the U.S. price index remains at 100. Then the initial real exchange rate is:

After the peso depreciates and the Mexican price level increases, the real exchange rate is:

In this example, the peso has depreciated substantially in terms of the U.S. dollar, but the real exchange rate between the peso and the U.S. dollar hasn’t changed at all. And because the real peso–U.S. dollar exchange rate hasn’t changed, the nominal depreciation of the peso against the U.S. dollar will have no effect either on the quantity of goods and services exported by Mexico to the United States or on the quantity of goods and services imported by Mexico from the United States.

To see why, consider again the example of a hotel room. Suppose that this room initially costs 1,000 pesos per night, which is $100 at an exchange rate of 10 pesos per dollar. After both Mexican prices and the number of pesos per dollar rise by 50%, the hotel room costs 1,500 pesos per night—but 1,500 pesos divided by 15 pesos per dollar is $100, so the Mexican hotel room still costs $100. As a result, a U.S. tourist considering a trip to Mexico will have no reason to change plans.

The same is true for all goods and services that enter into trade: the current account responds only to changes in the real exchange rate, not the nominal exchange rate. A country’s products become cheaper to foreigners only when that country’s currency depreciates in real terms, and those products become more expensive to foreigners only when the currency appreciates in real terms. As a consequence, economists who analyze movements in exports and imports of goods and services focus on the real exchange rate, not the nominal exchange rate.

Figure 34-7 illustrates just how important it can be to distinguish between nominal and real exchange rates. The line labeled “Nominal exchange rate” shows the number of pesos it took to buy a U.S. dollar from 1993 to 2013. As you can see, the peso depreciated massively over that period. But the line labeled “Real exchange rate” shows the real exchange rate: it was calculated using Equation 34-4, with price indexes for both Mexico and the United States set so that 1993 = 100. In real terms, the peso depreciated between 1994 and 1995, but not by nearly as much as the nominal depreciation. By 2013, the real peso–U.S. dollar exchange rate was just about back where it started.

A useful tool for analyzing exchange rates, closely connected to the concept of the real exchange rate, is known as purchasing power parity. The purchasing power parity between two countries’ currencies is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country. Suppose, for example, that a basket of goods and services that costs $100 in the United States costs 1,000 pesos in Mexico. Then the purchasing power parity is 10 pesos per U.S. dollar: at that exchange rate, 1,000 pesos = $100, so the market basket costs the same amount in both countries.

Calculations of purchasing power parities are usually made by estimating the cost of buying broad market baskets containing many goods and services—everything from automobiles and groceries to housing and telephone calls. But as the following For Inquiring Minds explains, once a year the magazine The Economist publishes a list of purchasing power parities based on the cost of buying a market basket that contains only one item—a McDonald’s Big Mac.

Nominal exchange rates almost always differ from purchasing power parities. Some of these differences are systematic: in general, aggregate price levels are lower in poor countries than in rich countries because services tend to be cheaper in poor countries. But even among countries at roughly the same level of economic development, nominal exchange rates vary quite a lot from purchasing power parity. Figure 34-8 shows the nominal exchange rate between the Canadian dollar and the U.S. dollar, measured as the number of Canadian dollars per U.S. dollar, from 1990 to 2013, together with an estimate of the purchasing power parity exchange rate between the United States and Canada over the same period.

The purchasing power parity didn’t change much over the whole period because the United States and Canada had about the same rate of inflation. But at the beginning of the period the nominal exchange rate was below purchasing power parity, so a given market basket was more expensive in Canada than in the United States. By 2002 the nominal exchange rate was far above the purchasing power parity, so a market basket was much cheaper in Canada than in the United States.

Over the long run, however, purchasing power parities are pretty good at predicting actual changes in nominal exchange rates. In particular, nominal exchange rates between countries at similar levels of economic development tend to fluctuate around levels that lead to similar costs for a given market basket. In fact, by July 2005 the nominal exchange rate between the United States and Canada was C$1.22 per US$1—just about the purchasing power parity. And by 2013 the cost of living was once again higher in Canada than in the United States.