An exchange rate is a price of one currency in another. We quote domestic currency units per unit of foreign currency. If that rate rises from 4 to 5, one foreign unit costs more domestic money: the domestic currency has depreciated. A foreign-currency debt of 100 then costs 500 rather than 400 domestic units to repay, before interest or fees.
A domestic-currency deposit does not physically leave the monetary system and become a foreign unit. Foreign-exchange dealers and banks exchange claims, often through correspondent accounts. A buyer of foreign currency generally needs a counterparty willing to accept the domestic claim. Who ends up holding those claims and which bank settles in which currency are the useful questions.
Convert a payment without confusing the two currencies
Keep the unit beside every amount before multiplying. Consider an additional paper example in which a domestic importer must pay a foreign supplier 80 foreign units next month. At a quote of 4 domestic units per foreign unit, the importer needs 320 domestic units. Multiplying 80 by 4 cancels the foreign unit in the conversion and leaves domestic units. If the quote becomes 5 before payment, the requirement becomes 400 domestic units. The supplier still receives 80 foreign units. The extra 80 domestic units reflect a changed conversion price, not another delivery or an increase in the foreign invoice.
Suppose the importer has a domestic deposit of 350 and no other liquid assets. At the first quote it could exchange 320 and retain 30. At the second quote it is short of 50 because 400 exceeds 350 by 50. Its domestic bank balance did not shrink when the exchange rate moved. Its ability to meet this particular foreign obligation did shrink. This is a payment shortage caused by currency mismatch. Whether the firm is insolvent requires valuing its other assets and obligations too. One unpaid invoice does not supply a complete balance sheet.
To continue this payment sequence, assume the importer obtains a separate domestic bank loan of 50. Its domestic deposit rises from 350 to 400, and it takes on a loan liability of 50. The bank adds a loan asset and a deposit liability of 50. Approval is an assumption, not a consequence of the currency shortage. This funding transaction supplies the missing domestic balance before the exchange; finding a currency dealer alone would not do so.
To trace the exchange itself, assume one dealer holds deposits in both currencies at the same banks as the importer. Ignore fees. The importer gives up a domestic deposit of 400 and receives a foreign deposit of 80. The dealer receives the domestic deposit of 400 and gives up its foreign deposit of 80. Each bank transfers a liability between its customers. Neither bank needs to erase 400 domestic units and manufacture 80 foreign units. These are exchanges of existing claims. If the customers use different banks, the banks must also settle the relevant obligations in each currency through the appropriate payment arrangements.
The importer then pays the supplier from its foreign deposit. Its foreign deposit falls by 80, and the supplier's rises by 80. Payment extinguishes the importer's invoice liability and the supplier's receivable, meaning the supplier's claim for payment. The supplier already recorded the sale separately from collecting the money. This distinction prevents counting a sale twice as income. The dealer's exchange and the supplier's receipt are separate transactions with separate counterparties. Commercial banks may use correspondent banks, which hold accounts and make payments for other banks, rather than holding direct central-bank accounts in every currency. After conversion and payment, the importer has no deposits left in this example. Its invoice is settled, but the new domestic loan of 50 remains due.
The inverse quotation describes the same exchange with a different unit. At 4 domestic units per foreign unit, one domestic unit buys 0.25 foreign units. At 5, it buys 0.20. The first quote rises by 1 divided by 4, or 25%. The inverse falls by 0.05 divided by 0.25, or 20%. There is no disagreement between the two calculations. Each percentage uses its own starting denominator. Whenever someone says the currency moved by a percentage, ask which currency is in the numerator and what dates the comparison uses. Otherwise the sign and size can both mislead.