Exchange Rates and International Transactions
Exchange rates play a central role in international trade because they allow us to compare
the prices of goods and services produced in different countries. A consumer deciding
which of two American cars to buy must compare their dollar prices, for example,
(for a Lincoln Continental) or (for a Ford Taurus). But how is the same
consumer to compare either of these prices with the 2,500,000 Japanese yen
it costs to buy a Nissan from Japan? To make this comparison, he or she must know the
relative price of dollars and yen.
The relative prices of currencies are reported daily in newspapers’ financial sections.
Table 14-1 shows the dollar exchange rates for currencies traded in London at 4 P.M. on
November 30, 2010, as reported in the Financial Times. An exchange rate can be quoted in
two ways: as the price of the foreign currency in terms of dollars (for example, $0.01194
per yen) or as the price of dollars in terms of the foreign currency (for example, per
dollar). The first of these exchange rate quotations (dollars per foreign currency unit) is
said to be in direct (or “American”) terms, the second (foreign currency units per dollar) in
indirect (or “European”) terms.
Households and firms use exchange rates to translate foreign prices into domestic currency
terms. Once the money prices of domestic goods and imports have been expressed
in terms of the same currency, households and firms can compute the relative prices that
affect international trade flows.
Domestic and Foreign Prices
If we know the exchange rate between two countries’ currencies, we can compute the
price of one country’s exports in terms of the other country’s money. For example, how
many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British
pounds ? The answer is found by multiplying the price of the sweater in pounds, 50,
by the price of a pound in terms of dollars—the dollar’s exchange rate against the pound.
At an exchange rate of per pound (expressed in American terms), the dollar price of
the sweater is
(1.50$/£) * (£50) = $75.
$1.50
(£50)
¥83.77
(¥2,500,000)
$44,000 $22,000
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 321
322 PART THREE Exchange Rates and Open-Economy Macroeconomics
A change in the dollar/pound exchange rate would alter the sweater’s dollar price. At
an exchange rate of per pound, the sweater would cost only
assuming its price in terms of pounds remained the same. At an exchange rate of per
pound, the sweater’s dollar price would be higher, equal to
Changes in exchange rates are described as depreciations or appreciations. A depreciation
of the pound against the dollar is a fall in the dollar price of pounds, for example, a change in
the exchange rate from per pound to per pound. The preceding example shows
that all else equal, a depreciation of a country’s currency makes its goods cheaper for foreigners.
A rise in the pound’s price in terms of dollars—for example, from per pound
to per pound—is an appreciation of the pound against the dollar. All else equal, an
appreciation of a country’s currency makes its goods more expensive for foreigners.
The exchange rate changes discussed in the example simultaneously alter the prices
Britons pay for American goods. At an exchange rate of per pound, the pound price
of a pair of American designer jeans costing is A change
in the exchange rate from per pound to per pound, while a depreciation of
the pound against the dollar, is also a rise in the pound price of dollars, an appreciation of
the dollar against the pound. This appreciation of the dollar makes the American jeans
more expensive for Britons by raising their pound price from to
($45)/(1.25 $/£) = £36.
£30
$1.50 $1.25
$45 ($45)/(1.50 $/£) = £30.
$1.50
$1.75
$1.50
$1.50 $1.25
(1.75 $/£) * (£50) = $87.50.
$1.75
(1.25 $/£) * (£50) = $62.50,
$1.25
TABLE 14-1 Exchange Rate Quotations
Source: Data from Financial Times, December 1, 2010, p. 24.
The change in the exchange rate from per pound to per pound—an appreciation
of the pound against the dollar but a depreciation of the dollar against the pound—
lowers the pound price of the jeans from to
As you can see, descriptions of exchange rate changes as depreciations or appreciations
can be bewildering, because when one currency depreciates against another, the second
currency must simultaneously appreciate against the first. To avoid confusion in discussing
exchange rates, we must always keep track of which of the two currencies we are
examining has depreciated or appreciated against the other.
If we remember that a depreciation of the dollar against the pound is at the same time
an appreciation of the pound against the dollar, we reach the following conclusion: When a
country’s currency depreciates, foreigners find that its exports are cheaper and domestic
residents find that imports from abroad are more expensive. An appreciation has opposite
effects: Foreigners pay more for the country’s products and domestic consumers pay less
for foreign products.
Exchange Rates and Relative Prices
Import and export demands, like the demands for all goods and services, are influenced by
relative prices, such as the price of sweaters in terms of designer jeans. We have just seen
how exchange rates allow individuals to compare domestic and foreign money prices by
expressing them in a common currency unit. Carrying this analysis one step further, we
can see that exchange rates also allow individuals to compute the relative prices of goods
and services whose money prices are quoted in different currencies.
An American trying to decide how much to spend on American jeans and how much to
spend on British sweaters must translate their prices into a common currency to compute
the price of sweaters in terms of jeans. As we have seen, an exchange rate of per
pound means that an American pays for a sweater priced at in Britain. Because the
price of a pair of American jeans is , the price of a sweater in terms of a pair of jeans
is pairs of jeans per sweater. Naturally, a
Briton faces the same relative price of
pairs of jeans per sweater.
Table 14-2 shows the relative prices implied by exchange rates of per pound,
per pound, and per pound, on the assumption that the dollar price of jeans and
the pound price of sweaters are unaffected by the exchange rate changes. To test your understanding,
try to calculate these relative prices for yourself and confirm that the outcome
of the calculation is the same for a Briton and for an American.
The table shows that if the goods’ money prices do not change, an appreciation of the
dollar against the pound makes sweaters cheaper in terms of jeans (each pair of jeans buys
more sweaters) while a depreciation of the dollar against the pound makes sweaters more
$1.50 $1.75
$1.25
(£50 per sweater)/(£30 per pair of jeans) = 1.67
($75 per sweater)/($45 per pair of jeans) = 1.67
$45
$75 £50
$1.50
(£45)/(1.75 $/£) = £25.71.
£30
$1.50 $1.75
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 323
TABLE 14-2 $/£ Exchange Rates and the Relative Price of American
Designer Jeans and British Sweaters
Exchange rate ($/£) 1.25 1.50 1.75
Relative price (pairs of jeans/sweater) 1.39 1.67 1.94
Note: The above calculations assume unchanged money prices of $45 per pair of jeans and £50 per sweater.
324 PART THREE Exchange Rates and Open-Economy Macroeconomics
expensive in terms of jeans (each pair of jeans buys fewer sweaters). The computations
illustrate a general principle: All else equal, an appreciation of a country’s currency raises
the relative price of its exports and lowers the relative price of its imports. Conversely, a
depreciation lowers the relative price of a country’s exports and raises the relative price of
its imports.
Exchange rates play a central role in international trade because they allow us to compare
the prices of goods and services produced in different countries. A consumer deciding
which of two American cars to buy must compare their dollar prices, for example,
(for a Lincoln Continental) or (for a Ford Taurus). But how is the same
consumer to compare either of these prices with the 2,500,000 Japanese yen
it costs to buy a Nissan from Japan? To make this comparison, he or she must know the
relative price of dollars and yen.
The relative prices of currencies are reported daily in newspapers’ financial sections.
Table 14-1 shows the dollar exchange rates for currencies traded in London at 4 P.M. on
November 30, 2010, as reported in the Financial Times. An exchange rate can be quoted in
two ways: as the price of the foreign currency in terms of dollars (for example, $0.01194
per yen) or as the price of dollars in terms of the foreign currency (for example, per
dollar). The first of these exchange rate quotations (dollars per foreign currency unit) is
said to be in direct (or “American”) terms, the second (foreign currency units per dollar) in
indirect (or “European”) terms.
Households and firms use exchange rates to translate foreign prices into domestic currency
terms. Once the money prices of domestic goods and imports have been expressed
in terms of the same currency, households and firms can compute the relative prices that
affect international trade flows.
Domestic and Foreign Prices
If we know the exchange rate between two countries’ currencies, we can compute the
price of one country’s exports in terms of the other country’s money. For example, how
many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British
pounds ? The answer is found by multiplying the price of the sweater in pounds, 50,
by the price of a pound in terms of dollars—the dollar’s exchange rate against the pound.
At an exchange rate of per pound (expressed in American terms), the dollar price of
the sweater is
(1.50$/£) * (£50) = $75.
$1.50
(£50)
¥83.77
(¥2,500,000)
$44,000 $22,000
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 321
322 PART THREE Exchange Rates and Open-Economy Macroeconomics
A change in the dollar/pound exchange rate would alter the sweater’s dollar price. At
an exchange rate of per pound, the sweater would cost only
assuming its price in terms of pounds remained the same. At an exchange rate of per
pound, the sweater’s dollar price would be higher, equal to
Changes in exchange rates are described as depreciations or appreciations. A depreciation
of the pound against the dollar is a fall in the dollar price of pounds, for example, a change in
the exchange rate from per pound to per pound. The preceding example shows
that all else equal, a depreciation of a country’s currency makes its goods cheaper for foreigners.
A rise in the pound’s price in terms of dollars—for example, from per pound
to per pound—is an appreciation of the pound against the dollar. All else equal, an
appreciation of a country’s currency makes its goods more expensive for foreigners.
The exchange rate changes discussed in the example simultaneously alter the prices
Britons pay for American goods. At an exchange rate of per pound, the pound price
of a pair of American designer jeans costing is A change
in the exchange rate from per pound to per pound, while a depreciation of
the pound against the dollar, is also a rise in the pound price of dollars, an appreciation of
the dollar against the pound. This appreciation of the dollar makes the American jeans
more expensive for Britons by raising their pound price from to
($45)/(1.25 $/£) = £36.
£30
$1.50 $1.25
$45 ($45)/(1.50 $/£) = £30.
$1.50
$1.75
$1.50
$1.50 $1.25
(1.75 $/£) * (£50) = $87.50.
$1.75
(1.25 $/£) * (£50) = $62.50,
$1.25
TABLE 14-1 Exchange Rate Quotations
Source: Data from Financial Times, December 1, 2010, p. 24.
The change in the exchange rate from per pound to per pound—an appreciation
of the pound against the dollar but a depreciation of the dollar against the pound—
lowers the pound price of the jeans from to
As you can see, descriptions of exchange rate changes as depreciations or appreciations
can be bewildering, because when one currency depreciates against another, the second
currency must simultaneously appreciate against the first. To avoid confusion in discussing
exchange rates, we must always keep track of which of the two currencies we are
examining has depreciated or appreciated against the other.
If we remember that a depreciation of the dollar against the pound is at the same time
an appreciation of the pound against the dollar, we reach the following conclusion: When a
country’s currency depreciates, foreigners find that its exports are cheaper and domestic
residents find that imports from abroad are more expensive. An appreciation has opposite
effects: Foreigners pay more for the country’s products and domestic consumers pay less
for foreign products.
Exchange Rates and Relative Prices
Import and export demands, like the demands for all goods and services, are influenced by
relative prices, such as the price of sweaters in terms of designer jeans. We have just seen
how exchange rates allow individuals to compare domestic and foreign money prices by
expressing them in a common currency unit. Carrying this analysis one step further, we
can see that exchange rates also allow individuals to compute the relative prices of goods
and services whose money prices are quoted in different currencies.
An American trying to decide how much to spend on American jeans and how much to
spend on British sweaters must translate their prices into a common currency to compute
the price of sweaters in terms of jeans. As we have seen, an exchange rate of per
pound means that an American pays for a sweater priced at in Britain. Because the
price of a pair of American jeans is , the price of a sweater in terms of a pair of jeans
is pairs of jeans per sweater. Naturally, a
Briton faces the same relative price of
pairs of jeans per sweater.
Table 14-2 shows the relative prices implied by exchange rates of per pound,
per pound, and per pound, on the assumption that the dollar price of jeans and
the pound price of sweaters are unaffected by the exchange rate changes. To test your understanding,
try to calculate these relative prices for yourself and confirm that the outcome
of the calculation is the same for a Briton and for an American.
The table shows that if the goods’ money prices do not change, an appreciation of the
dollar against the pound makes sweaters cheaper in terms of jeans (each pair of jeans buys
more sweaters) while a depreciation of the dollar against the pound makes sweaters more
$1.50 $1.75
$1.25
(£50 per sweater)/(£30 per pair of jeans) = 1.67
($75 per sweater)/($45 per pair of jeans) = 1.67
$45
$75 £50
$1.50
(£45)/(1.75 $/£) = £25.71.
£30
$1.50 $1.75
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 323
TABLE 14-2 $/£ Exchange Rates and the Relative Price of American
Designer Jeans and British Sweaters
Exchange rate ($/£) 1.25 1.50 1.75
Relative price (pairs of jeans/sweater) 1.39 1.67 1.94
Note: The above calculations assume unchanged money prices of $45 per pair of jeans and £50 per sweater.
324 PART THREE Exchange Rates and Open-Economy Macroeconomics
expensive in terms of jeans (each pair of jeans buys fewer sweaters). The computations
illustrate a general principle: All else equal, an appreciation of a country’s currency raises
the relative price of its exports and lowers the relative price of its imports. Conversely, a
depreciation lowers the relative price of a country’s exports and raises the relative price of
its imports.
No comments:
Post a Comment