You know, to understand exchange rates, you really need to grasp one concept. Foreign exchange, i.e. foreign money, is really just another commodity to be bought and sold. This is where the term foreign exchange market comes from. It's a market, so there must be those who want to buy the currency and those who supply it. On the demand side, what reason or reasons could people possibly have to want to purchase foreign exchange? Well, there are three major reasons really. First, people want foreign money for travel and tourism. Second, foreign money is needed for trade to buy foreign goods and services. Third, foreign money is needed for investment purposes, be it financial investment, like purchase of foreign denominative financial assets, or real investment like building a new factory overseas. A change in any of these three components will alter the demand for foreign exchange. For example, a lot of recent Hollywood blockbuster movies have been filmed in New Zealand. What if this creates a sudden surge in tourists going to New Zealand? These tourists will need New Zealand dollars creating an increase in demand for that currency. Similarly, if US companies decide they'd like to build factories in New Zealand, real investment, or purchase New Zealand dollar denominative financial assets, financial investment, the demand for the New Zealand dollar would increase. Now, let's go back to the idea of the foreign exchange market with the New Zealand dollar being the foreign exchange. Initially, there's a certain supply of New Zealand dollars in a certain demand. The equilibrium price in this market is called the exchange rate. Okay, now let's throw the increase in demand for the New Zealand dollar into the picture. What happens to the value of the New Zealand dollar as more tourists travel there, or as more US companies invest? As with any commodity, when the demand for the New Zealand dollar increases, its value increases. We see the exchange rate in terms of the US dollar per New Zealand dollar increase. This is called an appreciation of the New Zealand dollar. When dealing with bilateral exchange rates like this one, that is to say the relative value of two currencies, it is necessarily the case that as one currency becomes stronger or more valuable relative to the other, in this case the New Zealand dollar is increasing in value relative to the US dollar. The other currency is decreasing in value or depreciating. In this example, as the New Zealand dollar appreciates, the US dollar is getting relatively weaker or depreciating. Okay, so changes in demand for currency will affect the exchange rate. What about changes in supply? Well, ultimately, who is it that controls the supply of foreign currency? It's a foreign government. If the US wanted to drive the value of its own currency up, it would decrease the supply of dollars. If it wanted to drive the value down, it would increase the supply of dollars. Why would a country want to manipulate its own currency value? Let me give you an example. Suppose you're a US furniture producer and government protection for the spotted owl means you can't get the lumber that you need domestically. So you call up a Canadian lumber mill, tell them you'd like to place an order and they tell you that the lumber's going to cost $50,000 Canadian dollars. I don't know about you, but my bank account doesn't happen to have any Canadian dollars in it. This is where the exchange rate comes in. If I can figure out how much one Canadian dollar costs, then I can use that to calculate how much $50,000 Canadian dollars will cost. The price of one Canadian dollar in terms of US dollars is the exchange rate, dollars per Canadian dollar. I checked the dollar per Canadian dollar exchange rate for April 7, 2010 on xrates.com and found that Canadian dollar was equivalent to 0.998 US dollars. Just as a side note, this nearly one-to-one parity between the two countries' currencies is highly unusual, more on that in a minute. So if one Canadian dollar costs 99.8 cents US currency, how much will $50,000 Canadian dollars cost? In the end, it will cost you $49,900 US dollars to purchase the Canadian lumber. Now let's take a little trip back in time and figure out how much that same $50,000 Canadian dollars worth of lumber would have cost in April of each year for the previous 20 years. When would you most like to have purchased that lumber? You can see by looking at the data that when the foreign currency is the cheapest, in this case, 2001 at $64 per Canadian dollar, the foreign imports are the cheapest, $32,000 US dollars. Even if the Canadian lumber mill sees the same $50,000 Canadian dollars every year, the price to the US importer changes as the exchange rate changes. When the Canadian dollar depreciates the lumber is cheaper and US importers will buy more lumber. On the flip side, as the Canadian dollar depreciates, the US dollars getting stronger relative to the Canadian dollar, or it's appreciating. While US consumers are enjoying a strong dollar and buying lots of Canadian goods, Canadians are seeing the US dollar and therefore US goods as more expensive. Canadians import fewer US products if the Canadian currency is weak. A weak Canadian dollar is good for Canada's trade balance as Canada's exports rise and imports fall. At the same time, the US trade balance gets worse, where importing more and exporting less. The effect of the currency value on the trade balance takes me back to the question, why would a country want to manipulate its own currency value? You now know the answer to this. If a country can keep its currency cheap, then it keeps its products cheap and foreign products expensive, both of which are good for the balance of trade. The US has certainly been after China during the first decade of the 21st century, China keeps its currency value artificially low in order to keep a favorable trade balance. Next time, comparative advantage and trade.