Exchange Rates
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An exchange rate is the rate at which the currency of one
country can be exchanged for the currency of another country.
NOTE: it is usually not the case that the currencies between 2
countries trade 1 for 1.
But before I get into the exchange rate idea I want to talk about
gasoline that you and I buy to operate most of our cars. Most
gas stations have signs that tell you the dollar price per gallon of
gas. For example, you might see a sign that says 1.99/gal. (by
the way, I say gas will be below $2/gal again someday).
When you and I buy gas we see the price FOR 1 GALLON. I
like to say the gas is UNITIZED to 1. But, if we wanted we
could talk about how much gas we could get for a dollar. Then
the dollar would be unitized.
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If we think about dollars and gallons, we originally said
$1.99 is like 1 gallon. But, now we want to think about
$1 is x gallons. If we cross multiply we have
1.99x = 1(1) and so we see x = 1/1.99 = .5025 gallons. This
means $1 buys .5025 gallons of gas.
Now, I am thinking most of us like to think in terms of the
gallons being unitized and we work with the dollars per gallon.
Let’s think about the currency used in parts of Europe, the Euro,
and the dollar. We will work with the exchange rate where the
Euro is unitized – dollars per Euro. But we could unitize the
dollar and talk about Euros per dollar.
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In a recent Friday edition of the Wall Street Journal I saw that the
exchange rate between the Euro and the dollar was
$1.3303 per Euro. (Note most papers will print exchange rates
in Friday editions.) The paper also shows that this means .75154
Euros will get $1. But let’s stick with dollars per Euro!
Now, let’s work with easier numbers in an example. Say at one
point in time the exchange rate is $1 per Euro. Then say there is
a change so that the Euro costs $1.25 ($1.25 per Euro).
In this example you see the dollar price of the Euro has gone up.
More of US money is needed to buy 1 Euro. In this case the
dollar has depreciated. The dollar has become weaker.
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Let’s do another example, shall we?
Say at one point in time the exchange rate is $1 per Euro. Then
say there is a change so that the Euro costs $0.75 ($0.75 per
Euro).
In this example you see the dollar price of the Euro has fallen.
Less of US money is needed to buy 1 Euro. In this case the
dollar has appreciated. The dollar has become stronger.
So, why do exchange rates change? This question is similar to
asking why does the price of gasoline change? The answer
starts with a statement that the price changes because of a
change in supply or demand.
The exchange rate (dollars per Euro, for example) is really just
the dollar price of foreign currency.
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Supply and demand for Euro
Note the demand for the
Euro is downward
sloping and supply of
Euros is upward sloping
from left to right similar
to what we saw before in
a market.
Dollars per
Euro
S
D
Quantity of
Euros
Here the price in the
market is dollars per
Euro (similar to the
market for gas where we
would talk of the dollar
price per gallon). 6
Euro market -demand
Every now and then people in the US get a hankerin for a
European product. The people in the US have a demand for
importing European goods and therefore they have a demand for
Euros because US folks need the Euros to pay the European
sellers.
Note the demand for Euros is downward sloping meaning at a
lower price a greater quantity is demanded.
The demand for Euros would shift right if people in US have
increased income (and therefore want more imports, as well as
domestic goods) or if their taste and preference for European
goods would grow. The demand for Euros would shift left if the
opposite would happen.
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Demand for Euro Grows
As the demand
for Euro grows
(Because we
S1
E2
want more
E1
European
D2
stuff), the
D1
exchange rate
rises and the
Q1 Q2
Quantity of
quantity traded
Euros
rises.
The result here is to have the exchange rate rise – the dollar price of
the Euro has risen. Thus it takes more dollars to buy one Euro. This
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means the dollar depreciates and the Euro has appreciated in value.
Dollars per
Euro
Euro market - Supply
European folks want US goods and services and with this they
supply Euros in the currency market.
Note the supply of Euros is upward sloping from left to right
indicating at higher dollar prices for Euros they would supply a
greater quantity of Euros.
The supply would shift to the right if the Europeans earn more
income or if their taste and preference for US goods and services
grow. The supply would shift left if the opposite things happen.
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Changes in the exchange rate
If the demand for Euro should grow (a reason is listed on a
previous slide, right?), or if the supply of Euro should fall the
dollar price of Euros will rise. This means the dollar depreciates
or the Euro appreciates. In other words, if our desire for their
goods rises or their desire for our goods falls, then their currency
appreciates while our depreciates.
The reverse happens if we do not like their goods as much as in the
past or if they have a greater desire for ours.
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European goods to Americans
and vice versa
Say that currently the exchange rate between the dollar and Euro is
$1.40 per Euro.
A meal in Europe that costs 15 Euros means 15 times 1.40 = $21
would be the money you would need to get the meal.
Similarly, a $14.95 music CD would require a European citizen have
14.95/1.40 = 10.68 Euros.
Say that currently the exchange rate between the dollar and yen
changes to $1.50 per Euro. The Euro has appreciated because 1 Euro
gets more of the dollar than before.
The meal in Europe now costs 15 times 1.50 = $22.50.
Similarly, a $14.95 music CD would require a european citizen have
14.95/1.50 = 9.97 Euros.
When the Euro appreciates European goods are more expensive to US
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citizens and US goods are cheaper to European citizens.
Do you like it when the price of gas rises? Probably not
because you have to pay more per gallon. In this sense the
dollar is weaker against gas.
Do you like it when the price of the Euro rises? Probably not
because you have to pay more per Euro. In this sense the
dollar is weaker against the Euro.
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