A foreign exchange rate is the price of one country's currency in terms of another country's currency.

"Appreciation of the dollar" means that a dollar will buy more units of another currency.

"Depreciation of the dollar" is the opposite.

Exchange rates determine the price consumers pay for imports and the price producers receive for exports.

Long run vs. short run.

Two main theories plus other factors.

PURCHASING POWER PARITY: exchange rates are ultimately determined by relative price levels in the two countries, through the mechanism of market equilibrium.

Other factors: tariffs and quotas; demand for imports and exports; productivity.

INTEREST PARITY: in market equilibrium, expected returns on domestic deposits = expected returns on foreign deposits.

Note: expected return on $deposits in terms of foreign currency = interest rate on $deposits + expected appreciation of the $.

Exchange rates move in the same direction as real interest rates.

An increase in a country's money supply will cause its currency to depreciate in the short run but not in the long run.