Exchange
Rates
Understand how currencies are valued relative to each other, what causes exchange rates to shift, and how these changes affect international trade and capital flows.
What Is an Exchange Rate?
An exchange rate is the price of one currency expressed in terms of another currency. It tells you how much of one currency you need to buy a single unit of a different currency.
Exchange rates matter because they determine the relative cost of goods, services, and financial assets across countries, directly influencing trade balances and investment flows.
Key Terms to Know
The Foreign Exchange Market
Exchange rates are determined in the foreign exchange (forex) market, where currencies are bought and sold. Like any market, the equilibrium rate is set by supply and demand.
Determinants of Exchange Rates
Shifts in Supply and Demand
Appreciation vs. Depreciation
| Appreciation | Depreciation | |
|---|---|---|
| Definition | Currency buys more foreign currency | Currency buys less foreign currency |
| Exports | More expensive abroad | Cheaper abroad |
| Imports | Cheaper domestically | More expensive domestically |
| Net Exports | Tend to decrease | Tend to increase |
| Cause example | Higher interest rates attract capital inflow | Higher inflation makes goods less competitive |
Floating vs. Fixed Rates
The Real Exchange Rate
The real exchange rate adjusts the nominal rate for differences in price levels. It measures the rate at which goods and services in one country trade for goods and services in another.
If a country has higher inflation than its trading partners, its real exchange rate rises: domestic goods become relatively more expensive, reducing net exports.
How to Analyze Exchange Rate Changes
Example 1: Rising U.S. Interest Rates
Suppose the Federal Reserve raises the federal funds rate. Foreign investors now find U.S. bonds more attractive, so they want to buy dollars.
Example 2: Higher U.S. Inflation
Suppose U.S. inflation rises relative to Europe. American goods become more expensive, so Europeans buy fewer U.S. products and Americans buy more European goods.
Example 3: Calculating the Real Rate
The nominal exchange rate is \( e = 110 \text{ yen/dollar} \). A basket of goods costs \( \$200 \) in the U.S. and \( ¥20{,}000 \) in Japan. Find the real exchange rate.
A real exchange rate of 1.10 means U.S. goods are 10% more expensive than Japanese goods when converted at current exchange rates. If this ratio rises above 1, U.S. exports become relatively more costly.
Exchange Rates and Net Exports
Common Mistakes to Avoid
Summary: Policy Effects on Exchange Rates
| Event | Effect on Dollar | Effect on Net Exports |
|---|---|---|
| Fed raises interest rates | Appreciates | Decrease |
| U.S. inflation rises | Depreciates | Increase |
| U.S. income rises (expansion) | Depreciates | Decrease (more imports) |
| Foreign demand for U.S. goods rises | Appreciates | Increase |
| Expansionary fiscal policy | Appreciates (higher rates via crowding out) | Decrease |
Question 1 of 5
If the U.S. interest rate increases relative to Europe, what happens to the value of the dollar?
Question 2 of 5
If the Japanese yen appreciates relative to the U.S. dollar, which of the following is most likely?
Question 3 of 5
Given: \( e = 120 \text{ yen/dollar} \), \( P_{\text{US}} = 150 \), \( P_{\text{Japan}} = 16{,}000 \). What is the real exchange rate?
Question 4 of 5
Under a fixed exchange rate system, if market forces would cause a currency to depreciate, the central bank must:
Question 5 of 5
Expansionary fiscal policy (increased government spending financed by borrowing) in the U.S. tends to cause the dollar to: