For example, if one U.S. dollar ($1) can be exchanged for 0.86 euros, the exchange rate would be represented as $1 for 0.86€. So if someone is traveling to Europe and needs to exchange their dollars into euros, they would have to give up $100 in exchange for 86€. If the dollar appreciates relative to the euro and the rate becomes $1 for 0.94€, the dollar now “buys” more euros. This makes buying European goods cheaper than they were before. U.S. imports from countries that use the euro would rise, and U.S. exports would fall as U.S.-made goods are now more expensive. Another example of currency appreciation is when one government increases spending or cuts taxes compared to another country’s government, or if there is an increase in investment demand by foreigners. If the U.S. government increases government spending or cuts taxes, this will cause interest rates to rise due to the increase in government bonds needed to pay for the spending. The higher interest rates will cause foreign investment to pour in. There would then be more units of foreign currency in circulation compared to before, which makes the U.S. dollar more valuable. In addition, an increase in investment demand by foreigners will increase the amount of foreign currency relative to U.S. dollars and will appreciate the U.S. dollar.
How Does Currency Appreciation Work?
The way a currency will appreciate depends on the exchange rate system. There are three exchange rate systems: floating exchange regime, fixed exchange regime, and a managed float regime.
Floating Exchange
In a floating exchange rate system, a currency’s value fluctuates with supply and demand created by capital flows—the movement of money in and out of countries for the purpose of investment in real estate, businesses, or for trade. With changes in the flow of capital, there will be an interest rate differential, which is the difference in interest rates on assets between two countries. If money flows into the country with a relatively high real interest rate, it can cause an increase in demand for that country’s currency. That increased demand can cause that country’s currency to appreciate.
Fixed Exchange
In a fixed exchange rate system, countries will intervene in the foreign exchange market to maintain the value of their currencies relative to another currency. An example of a fixed exchange rate system is during the Bretton Woods system from 1947-1973, in which other countries fixed their currencies to the U.S. dollar. Under a fixed exchange rate system, if Great Britain wanted to increase the value of the pound to maintain a set ratio, such as one U.S. dollar to 0.75 British pounds, it would buy pound-denominated assets to take pounds out of the money supply. This would make the pound more valuable relative to the U.S. dollar and cause the British pound to appreciate. If the foreign exchange rate moves away from the set ratio during the normal business activity of trade, the British government would need to intervene to buy or sell assets to increase or decrease the money supply and maintain the set ratio it wants.
Managed Floating Exchange
Currency appreciation in a managed float system will have some elements from both a floating exchange rate system and a fixed exchange rate system. While there is free movement of capital in a managed float that allows the currency to fluctuate daily with other currencies, the government will intervene if there is short-term market disorder or to maintain exchange rate stability. For example, if there is political uncertainty in a country with a managed-float regime, it will cause less foreign investment to enter, which will cause the currency to become less valuable. In response, the government may intervene and sell assets to take currency out of the money supply. This will cause the currency to appreciate, or become more valuable, relative to other foreign currencies.
