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).
(1) interest-rate differentials, (2) macro policy credibility (inflation/fiscal stance), and (3) political–institutional stability / rule of law.
Part I-B: What Determines Interest Rates?
FX moves fast because investors compare expected returns across countries. A clean way to learn this: interest rates are the “price of money”—and the price moves when inflation, growth, risk, and central-bank policy change.
- Central bank policy rate: reaction to inflation, jobs, and financial stability.
- Inflation expectations: higher expected inflation → higher nominal yields (Fisher effect).
- Real growth & productivity: stronger growth raises demand for funds → higher real rates (often).
- Fiscal stance & debt supply: bigger deficits can raise term premium / risk premium (context-dependent).
- Risk premium / safe-haven demand: “flight to safety” can push Treasury yields down even when risk is high.
- Global yield comparisons: if US yields rise relative to others, USD demand often rises (capital inflows).
USD Case Study: Why did the dollar strengthen when policy expectations shifted?
Use this as the template for exam answers: state the shock, say whether it shifts demand and/or supply, then predict appreciation (P* ↑) or depreciation (P* ↓).
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.
FX Value Playbook: Key Factors → Demand/Supply Shifts
For each factor, ask: does it increase demand for the currency (foreigners want to buy it), or increase supply (residents want to sell it)? Then predict the direction of P* (exchange rate).
- Higher expected real returns (rates/credibility) → D ↑ → currency appreciates.
- Higher inflation / weaker credibility → D ↓ and often S ↑ → currency depreciates.
- Risk-off / safe-haven flows → D ↑ for safe assets → appreciation.
- Wider trade deficit → S ↑ (more selling to pay imports) → depreciation (all else equal).
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. |
Impossible Trinity (Trilemma) • Interactive Game
Pick two policy goals and see what must be sacrificed. Use this when you discuss fixed FX regimes, capital controls, and monetary-policy independence.
Reserve Currency Weights Since 2000 (COFER)
Reserve currency status is about network effects + deep safe-asset markets + credibility. This chart uses an embedded teaching dataset (offline-safe) to show how shares evolved over time.
Appendix: USD Value in Practice — DXY, Trade-Weighted Dollar, and What “Strong USD” Means
Headlines say “the dollar is strong” — but strong vs what? In practice, you’ll see USD strength described using (1) a bilateral exchange rate (USD vs one currency), or (2) an index (USD vs a basket). This section turns that into an exam-ready checklist.
• EURUSD = dollars per euro. If USD strengthens, EURUSD tends to fall (euro buys fewer dollars).
• USDJPY = yen per dollar. If USD strengthens, USDJPY tends to rise (one dollar buys more yen).
Translation: “USD up” can look like a number going up or down depending on the quote.
USD indices: what they measure (and what they don’t)
| Measure | Meaning when it rises | Best use in class |
|---|---|---|
| DXY (US Dollar Index) | USD strengthens vs a fixed basket of major peers (mostly EUR-weighted). | Market headlines; “broad USD strength” vs majors. |
| Trade-weighted USD (broad/major) | USD strengthens vs a basket with weights tied to trade patterns. | Macro/competitiveness; trade deficit discussion; inflation pass-through. |
| Real trade-weighted USD | USD strengthens after adjusting for inflation differentials. | Long-run “valuation” talk (purchasing power / competitiveness). |
DXY basket (headline index) — what’s inside?
DXY is widely quoted, but it’s not “the whole world.” It is heavily driven by the EUR and includes only a small set of major currencies. Use this to explain why “USD index up” can still miss moves vs China, Mexico, Brazil, etc.
| Currency in basket | Typical weight (approx.) | Note |
|---|---|---|
| EUR | ~57.6% | So DXY often looks like an “inverse EUR” story. |
| JPY | ~13.6% | Risk-off episodes can move JPY differently than EUR. |
| GBP | ~11.9% | UK-specific shocks can move DXY via GBP. |
| CAD | ~9.1% | Commodity exposure; can diverge in oil moves. |
| SEK | ~4.2% | Small weight; still helps show “basket” logic. |
| CHF | ~3.6% | Safe-haven currency; can offset some risk episodes. |
USD Index Dashboard (trade-weighted, optional live data)
The chart below uses trade-weighted USD indices (Broad + Major currencies). When hosted online (http/https), it can fetch live data from FRED. When opened locally (file://), the page falls back to a small embedded sample.
So… what does a “strong USD” mean in real life?
| Channel | Who “wins” | Who “loses” / common issues |
|---|---|---|
| Imports & consumer prices | Imported goods cheaper; can reduce inflation pressure. | May widen trade deficit if import demand rises. |
| Exports & US firms | US buyers of foreign inputs benefit. | Exporters face tougher competition; USD earnings translation hurts multinationals. |
| Commodities (USD pricing) | Can reduce USD commodity prices (sometimes). | Commodity exporters may feel pressure if prices fall in USD terms. |
| Global dollar debt | US funding markets look “safer.” | Non-US borrowers with USD debt face higher repayment burden → stress risk. |
| Financial conditions | Safe-haven flows support liquidity in Treasuries. | Can tighten global conditions; can contribute to EM outflows and crises. |
- Index ≠ every pair: USD can strengthen vs EUR but weaken vs JPY.
- Basket composition bias: DXY is major-currency heavy and EUR-heavy.
- Nominal vs real: “Strong USD” in nominal terms can differ from real competitiveness after inflation.
- Overshooting: Short-run FX can move more than fundamentals (expectations + positioning).
In-Class Drill: “Strong USD” → Quote Mechanics → Demand/Supply
Summary & Forecasting: What Determines Currency Value?
Don’t memorize headlines—memorize a checklist. For any currency, ask: (1) do expected real returns move in its favor (rate differential), (2) does global risk feel risk-off or risk-on (safe-haven demand), and (3) does the shock change credibility (inflation, fiscal sustainability, institutions)?
| Forces that can strengthen a currency (D↑ and/or S↓) | Forces that can weaken a currency (D↓ and/or S↑) |
|---|---|
|
|
Near term: USD tends to stay strong when US real yields rise and/or the world turns risk-off (safe-haven bid).
Longer run: USD can weaken if inflation credibility deteriorates or if fiscal/geopolitical pressures reduce global demand for USD assets.
Module 7 Quiz
Take the quiz to check your understanding of how shocks move FX demand (D) and supply (S) and what that implies for appreciation vs. depreciation.
Homework
Use the dedicated homework page to practice D/S curve shifts and write a short explanation for each scenario. Submit your answers (graphs + 3–5 sentences per scenario) with the first midterm.