To a large extent, the fixed exchange rates set by the Bretton Woods agreements in 1944 served as international monetary arrangements until 1971. Then, in 1971 the United States and most other countries decided to abandon the fixed exchange rate system in favor of floating, or market-determined, exchange rates. While governments still intervene to ensure that exchange rate movements are "orderly," exchange rates today are largely determined by the unregulated forces of supply and demand.
Understanding how an economy interacts with the rest of the world when exchange rates are not fixed is not as simple as when we assume fixed exchange rates. Exchange rates determine the price of imported goods relative to domestic goods and can have significant effects on the level of imports and exports. Consider a 20 percent drop in the value of the dollar against the British pound. Dollars buy fewer pounds and pounds buy more dollars. Both British residents, who now get more dollars for pounds, and U.S. residents, who get fewer pounds for dollars, find that U.S. goods and services are more attractive. Exchange rate movements have important impacts on imports, exports, and the movement of capital between countries.
The Market for Foreign Exchange
What determines exchange rates under a floating rate system? To explore this, we assume there are just two countries, the United States and Great Britain. It is easier to understand a world with only two countries and most of the points that will be made can be generalized to a world with many trading partners.
 The Supply of, and Demand for, Pounds Governments, private citizens, banks, and corporations exchange pounds for dollars and dollars for pounds every day. In our two-country case, those who demand pounds are holders of dollars seeking to exchange them for pounds. Those who supply pounds are holders of pounds seeking to exchange them for dollars. It is important not to confuse the supply of dollars (or pounds) on the foreign exchange market with the U.S. (or British) money supply. The latter is the sum of all the money currently in circulation. The supply of dollars on the foreign exchange market is the number of dollars that holders seek to exchange for pounds in a given time period. The demand for, and supply of, dollars on foreign exchange markets determines exchange rates; the demand for money balances and the total domestic money supply determine the interest rate.
The common reason for exchanging dollars for pounds is to buy something produced in Great Britain. U.S. importers who purchase Jaguar automobiles or Scotch whiskey must pay with pounds. U.S. citizens traveling in Great Britain who want to ride the train, stay in a hotel, or eat at a restaurant must acquire pounds for dollars to do so. If a U.S. corporation builds a plant in Great Britain, it must pay for that plant in pounds.
At the same time, some people may want to buy British stocks or bonds. Implicitly, when U.S. citizens buy a bond issued by the British government or by a British corporation, they are making a loan, but the transaction requires a currency exchange. The British bond seller must ultimately be paid in pounds.
On the supply side of the market, the situation is reversed. Here we find people---usually British citizens---holding pounds they want to use to buy dollars. Again, the common reason is to buy things produced in the United States. If a British importer decides to import golf carts made in Georgia, the producer must be paid in dollars. British tourists visiting New York may ride in cabs, eat in restaurants, and tour Ellis Island. Doing these things requires dollars. When a British firm builds an office complex in Los Angeles, it must pay the contractor in dollars.
In addition to buyers and sellers who exchange money to engage in transactions, some people and institutions hold currency balances for speculative reasons. If I think the U.S. dollar is going to decline in value relative to the pound, I may want to hold some of my wealth in the form of pounds.
When the price of pounds (the exchange rate) is lower, it takes fewer dollars to buy British goods and services, to build a plant in Liverpool, to travel to London and so forth. Lower net prices (in Dallas) should increase the demand for British-made products and encourage investment and travel in Great Britain. If prices (in pounds) in Britain do not change, an increase in the quantity of British goods and services demanded by foreigners will increase the quantity of pounds demanded.
At a higher exchange rate, each pound buys more dollars, making the price of U.S.-produced goods and services lower to the British. The British are more apt to buy U.S.-made goods when the price of pounds is high (the value of the dollar is low). An increase in British demand for U.S. goods and services is likely to increase the quantity of pounds supplied.
The Equilibrium Exchange Rate When exchange rates are allowed to float, they are determined the same way other prices are determined:
The equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity of that currency supplied.
An excess demand for pounds (quantity demanded in excess of quantity supplied) will cause the price of pounds to rise---the pound will appreciate with respect to the dollar. An excess supply of pounds will cause the price of pounds to fall---the pound will depreciate with respect to the dollar.
*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 696-699*
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