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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

Dollars per Euro

Quantity of Euros

D

S

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.

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).

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Euro market -demandEvery 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

Dollars per Euro

Quantity of Euros

D1

S1

As the demand for Euro grows (Because we want more European stuff), the exchange rate rises and the quantity traded rises.

E1D2

E2

Q1 Q2

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 means the dollar depreciates and the Euro has appreciated in value.

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Euro market - SupplyEuropean 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 rateIf 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 citizens and US goods are cheaper to European citizens.

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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.