Exchange Rates

In September 1992, George Soros's Quantum Fund shorted the British pound, forcing the UK out of the European Exchange Rate Mechanism. The pound depreciated 15% in days. The episode illustrated that fixed exchange rate commitments are only as credible as the reserves and political will behind them -- and that speculative attacks can overwhelm central bank defenses when capital is mobile and fundamentals are misaligned.

Exchange rates sit at the intersection of monetary policy, trade, and capital flows. A dollar appreciation makes U.S. exports more expensive and imports cheaper, shifting purchasing power abroad. A depreciation does the reverse -- but also raises import prices and can fuel inflation. Central banks must weigh all of these transmission channels when setting policy in an open economy.

Exchange rates are determined in the short run by capital flows responding to interest rate differentials, risk sentiment, and expectations about future policy. In the medium run, purchasing power parity (PPP) exerts a gravitational pull: currencies tend to move toward the level that equalizes the price of a common basket of goods across countries.

The Mundell-Fleming model connects exchange rates to monetary policy and output in an open economy. It shows that the effect of a monetary expansion depends on whether the exchange rate is fixed or floating -- and that a country cannot simultaneously maintain a fixed exchange rate, free capital mobility, and independent monetary policy. This is the impossible trilemma.