Exchange Rate
What is Exchange Rate?
An exchange rate is the price of one country's currency expressed in terms of another currency.
It is set in the foreign exchange market by the supply of and demand for currencies. A higher exchange rate (appreciation) makes imports cheaper and exports more expensive. Exchange rates affect net exports and aggregate demand.
Exchange Rate: a worked example
Suppose the quoted rate is 100 yen per dollar. One yen therefore costs 1 ÷ 100 = $0.01. A $30 item priced in yen sells for 30 × 100 = 3,000 yen, and the units cancel neatly, since dollars times yen per dollar leaves yen. Now let demand for dollars rise so the rate moves to 125 yen per dollar. The same $30 item now costs 30 × 125 = 3,750 yen, and one yen is worth 1 ÷ 125 = $0.008. Notice the two percentage changes do not match: the dollar gained (125 - 100) ÷ 100 = 25% against the yen, while the yen lost (0.010 - 0.008) ÷ 0.010 = 20% against the dollar. Reciprocal quotes always produce asymmetric percentages.
The mistake students make with exchange rate
On the foreign exchange diagram, students label the vertical axis with the word price, or with a single currency name, and then cannot say which direction represents appreciation. In the market for dollars, that axis must read units of foreign currency per dollar, while the horizontal axis is the quantity of dollars traded. Labeled properly, a rightward shift in demand for dollars raises the equilibrium value on the axis, which is appreciation by definition. The companion error is forgetting that the same event shows up in the other market as a shift in the supply of foreign currency.
Exchange Rate questions
How do you read an exchange rate quote?
Read the quote as a price with units attached. A rate of 1.30 dollars per pound means one pound costs 1.30 dollars, so pounds are the good being bought and dollars are the price tag. Converting 200 pounds into dollars means multiplying: 200 × 1.30 = 260 dollars, because the pound units cancel. Going the other way means dividing by the rate. Flipping the quote gives its reciprocal, 1 ÷ 1.30 = about 0.77 pounds per dollar.
What determines exchange rates in a floating system?
Supply and demand for the currency in the foreign exchange market set the rate. Demand comes from foreigners buying domestic exports, foreigners investing in domestic assets, and speculators expecting the currency to rise. Supply comes from domestic residents buying imports and acquiring foreign assets. Relative real interest rates, relative inflation rates, relative growth, and expectations drive those shifts. No official rate is announced, so the price moves continuously as new orders arrive.
How do exchange rates affect aggregate demand?
Exchange rates reach aggregate demand through the net exports component. A stronger domestic currency makes exports pricier abroad and imports cheaper at home, so net exports fall and aggregate demand shifts left. A weaker currency does the reverse, lifting net exports and shifting aggregate demand right. This channel also gives monetary policy extra force in an open economy, since a rate cut both encourages investment spending and weakens the currency.
Formula / Example
This is the live Exchange Rates sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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