Exchange rates
In an open economy, trade and finance link countries. Exchange rates, the prices of currencies, connect them.
What an exchange rate is
An exchange rate is the price of one currency in terms of another. If 1 euro buys 1.10 US dollars, the euro-dollar rate is 1.10. When a currency buys more foreign currency than before, it has appreciated; when it buys less, it has depreciated.
Effects of exchange rate changes
When a currency appreciates, its exports become more expensive abroad and imports become cheaper at home, which tends to reduce net exports. Depreciation does the reverse. A weaker currency also raises import prices, adding to inflation.
Supply and demand for currencies
Exchange rates in floating systems are set in foreign exchange markets. Demand for a currency comes from foreigners buying the country's exports and assets; supply comes from residents buying imports and foreign assets. Daily trading in foreign exchange markets exceeds 7 trillion dollars, according to the Bank for International Settlements.
What moves exchange rates
Exchange rates respond to interest rate differences (higher rates attract foreign capital), inflation (high inflation erodes a currency's value), growth prospects, trade flows, political risk, and market sentiment. In the short run, capital flows and expectations dominate; in the long run, relative prices matter more.
Purchasing power parity
Purchasing power parity (PPP) suggests that exchange rates should adjust so a basket of goods costs the same everywhere. The Economist's Big Mac index compares burger prices to test this light-heartedly. PPP holds only loosely and over long periods, because many goods and services are not traded.
Real exchange rates
The real exchange rate adjusts the nominal exchange rate for price levels, measuring how many foreign goods one domestic good can buy. If a country's inflation is higher than its trading partners', its real exchange rate rises unless its currency depreciates, making its goods less competitive.
Exchange rate regimes
Under a floating exchange rate, the market sets the rate (US dollar, euro, Japanese yen). Under a fixed (pegged) rate, the central bank commits to a set rate, buying or selling its currency to maintain it (Hong Kong dollar, Saudi riyal). Many countries use managed floats in between. Some countries use another's currency or share one, as in the euro area.
Worked example
A US company sells a machine for 10,000 dollars. When 1 euro = 1.00 dollar, it costs a European buyer 10,000 euros. If the dollar appreciates so that 1 euro = 0.80 dollars, the same machine costs 12,500 euros. European demand for the machine falls, illustrating how appreciation hurts exports.
Key takeaways
An exchange rate is the price of one currency in another. Appreciation makes exports dearer and imports cheaper; depreciation does the reverse. Floating rates are set by supply and demand, influenced by interest rates, inflation, and expectations. PPP holds loosely in the long run. Real exchange rates adjust for price levels. Regimes range from floating to fixed to currency unions.
Flashcard
Price of one currency in another
Check your understanding
If the British pound appreciates against the dollar, what happens to British exports to the US?