Part I: What Determines the Strength of a Currency?
In a floating-rate system, currency value is determined by market demand and supply. In a pegged system, authorities intervene to maintain a target level (or band).
Three core drivers to emphasize in class discussion:
(1) interest-rate differentials, (2) macro policy credibility (inflation/fiscal stance), and (3) political–institutional stability / rule of law.
(1) interest-rate differentials, (2) macro policy credibility (inflation/fiscal stance), and (3) political–institutional stability / rule of law.
Examples of “strong” vs. “weak” currencies (conceptual)
| Category | Typical examples | Why (high-level) |
|---|---|---|
| Strong / safe-haven | USD, CHF, JPY (often), SGD (often) | Deep markets, institutional credibility, stable inflation, and “flight-to-safety” demand during global stress. |
| Commodity-linked | CAD (oil), AUD (commodities), NOK (oil/gas) | Terms-of-trade sensitivity: commodity booms can strengthen; busts can weaken. |
| Weak / fragile | High-inflation / capital-control / crisis economies | High inflation, low credibility, FX shortages, sanctions risk, political instability, shallow financial markets. |
Interactive Game: FX Supply–Demand Shifts
Use this to practice the logic: a “stronger currency” is an appreciation (higher price of the currency), typically caused by higher demand and/or lower supply in FX markets.
Demand (D)
Supply (S)
P = exchange rate (price of the currency)
Q = quantity of currency traded
0
Think: higher foreign demand for your currency (e.g., higher returns, safe-haven flows).
0
Think: more selling of your currency (e.g., inflation fears, capital flight, import surges).
Equilibrium exchange rate (P*)
—
Higher P* = appreciation (stronger currency)
Equilibrium quantity (Q*)
—
Quantity can rise or fall when both curves move
Interpretation
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Part II: Fixed Exchange Rate vs. Floating Exchange Rate
Most major currencies float, but even floaters may intervene during extreme volatility. A fixed (pegged) system requires reserves and credibility to defend the peg/band.
| System | Pros (advantages) | Cons (disadvantages) |
|---|---|---|
| Fixed / Pegged | Stability for trade/investment; can help anchor inflation expectations; reduces short-term FX uncertainty. | Requires FX reserves and policy discipline; limits monetary policy autonomy; may create misalignment and crisis risk if the peg becomes unsustainable. |
| Floating | Automatic adjustment to shocks; monetary policy independence; less need for large reserves; prices reflect changing fundamentals. | Higher volatility; can amplify speculation and pass-through to inflation; complicates planning for trade/investment. |
Discussion prompt: Should China move toward a more flexible (floating) rate while Norway adopts a fixed rate? Use trade structure, capital mobility, and monetary-policy objectives to justify.
The Impossible Trinity (Trilemma) Simulator
The trilemma says a country cannot simultaneously have: (1) a fixed exchange rate, (2) free capital mobility, and (3) independent monetary policy. You can only choose two.
Fixed exchange rate
FX stabilityKeep the currency stable vs. another currency or basket (peg or narrow band).
Free capital flows
Open financial accountAllow money to move in/out freely (few capital controls).
Independent monetary policy
Interest-rate controlSet domestic interest rates for inflation/employment objectives.
Select any two options above. The simulator will tell you what you must sacrifice, plus real-world style examples.
Homework (Due with the first midterm exam)
A. Currency strength (conceptual)
- How do inflation, real interest rates, public debt, and crisis risk shift currency demand and supply?
- Give one real-world example of a “safe-haven” flow and explain its FX impact.
B. Fixed vs floating (policy)
- In your view, should China adopt a more flexible exchange rate while Norway implements a fixed exchange rate? Why or why not?
- Use: economic stability, trade dependencies, capital flow policies, and monetary policy objectives.
C. Impossible Trinity
- Based on the trilemma, which two goals should China prioritize today? Which one should it sacrifice? Explain.
- Which two goals should Norway prioritize? Explain your reasoning.
References (for students)
- Forbes (Barrington): “What Determines the Strength of a Currency?” (conceptual drivers)
- Investopedia: “How Are International Exchange Rates Set?” (fixed vs floating mechanics)
- IMF: trilemma framing and global financial cycle discussion
- HKMA: Linked Exchange Rate System (convertibility undertakings and band)
Educational disclaimer: This page is for classroom instruction only. Examples are simplified to teach core mechanisms; real FX markets include expectations, risk premia, microstructure, and policy constraints.