An exchange rate is the price of a currency in terms of another currency. For example, a dollar right now (12/11/18) is equal to 0.88 euros.
Factors that Affect an Exchange Rate
Tastes and Preferences
Let’s say American really want Japanese goods. In order to buy Japanese goods, they need Yens. So, the demand for Japanese yen goes up. By our knowledge of supply and demand, the price of Yens in dollars goes up.
When US has high inflation, they export less. Why? Because things cost more in the US than they do elsewhere. Likewise, they import more, because other countries have cheaper goods. So, the demand for US currency decreases, the demand for foreign currency increases. If the US wants to purchase more foreign currency, they must supply more USD. Likewise, foreign currencies don’t need to supply as much currency to buy USD. In the end, US currency depreciates and foreign currencies appreciate.
This is less related to currencies themselves and more related to imports/exports. When incomes in the US go up, Americans buy more in general, meaning imports increase. If imports increase, then Americans demand foreign income more. This means that the US supplies more income to exchange with foreign incomes. Therefore, the US dollar depreciates. Similarly, the demand for other currencies increases, so their currencies appreciate.
Let’s say the interest rate in the US is 15%, and the interest rate in Japan is 2%. Japanese people will want to convert their currency to US dollars to capitalize on the interest. Therefore, the demand for USD will increase.
Monetary Policy or Fiscal Policy
Using monetary policy, the federal reserve would engage in open market operations, buying bonds or lowering the discount rate or lower interest rates on excess reserves, etc. , lowering interest rates. Not only would this encourage greater consumption (less saving) and investment, but this would decrease the value of US currency. This results in greater exports and fewer imports. So, the economy would recover faster.
Using fiscal policy, the government would lower taxes or increase spending. The government is borrowing a lot of money to do this. So, interest rates rise (just because of law of supply and demand). Because interest rates rise, the value of the dollar increases. Now, exports decrease and imports increase. This reduces GDP growth, so the economy would recover slower.
Using monetary policy, the federal reserve would engage in open market operations, this time selling bonds for example. They will do this to raise interest rates. Therefore, consumption decreases, as people invest less, buy less, and save more. This has the double effect of increasing the value of the US dollar, resulting in increased imports and decreased exports. These both combine to decrease the GDP faster.
Using monetary policy, the government could lower taxes and decrease spending. With less demand for loans, interest rates decrease. This decreases the value of the USD, leading to more exports and fewer imports, reducing the effect on the GDP reduction.