What an exchange rate is and how it is measured

Overview

Exchange rate, appreciation and depreciation of a currency mean and strong currency make imports cheap and exports dear.

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Questions from this subtopic

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1. 1

   What is an exchange rate?

   Model answer

   An exchange rate is the price of one currency expressed in terms of another, for example the number of United States dollars that one pound will buy. Like any price it tells you what has to be given up to obtain something, so it converts prices in one country into prices that buyers in another country actually face. Because almost every internationally traded good, service and asset has to be paid for in the seller’s currency, the exchange rate acts as a link between the domestic price level and the prices faced by foreign customers and suppliers.

2. 2

   What do appreciation and depreciation of a currency mean?

   Model answer

   An appreciation is a rise in the value of a currency against another, so a unit of the domestic currency buys more foreign currency than before. A depreciation is a fall in its value, so a unit of the domestic currency buys less foreign currency. If the pound moves from 1.20 to 1.30 United States dollars it has appreciated, and if it moves from 1.20 to 1.10 dollars it has depreciated.

3. 3

   The exchange rate is 1 pound = 1.25 United States dollars. Calculate how many dollars 4,000 pounds converts to, and how many pounds 3,000 dollars converts to.

   Model answer

   To convert pounds into dollars, multiply by the rate: 4,000 times 1.25 = 5,000 dollars. To convert dollars into pounds, divide by the rate: 3,000 divided by 1.25 = 2,400 pounds. The rule is to multiply when moving in the direction the rate is quoted and to divide when moving against it.

4. 4

   A car made in the United Kingdom sells for 40,000 pounds. Calculate its price to a United States buyer when the exchange rate is 1 pound = 1.25 dollars and again after sterling depreciates to 1 pound = 1.10 dollars, and find the percentage change.

   Model answer

   At 1.25 dollars to the pound the car costs 40,000 times 1.25 = 50,000 dollars. At 1.10 dollars to the pound it costs 40,000 times 1.10 = 44,000 dollars. The fall is 6,000 dollars, which is 6,000 divided by 50,000 = 0.12, or 12%, and this matches the 12% fall in the exchange rate from 1.25 to 1.10, since the foreign-currency price of an unchanged sterling price moves in exact proportion to the rate. The United Kingdom exporter has become cheaper in the American market without changing its own price.

5. 5

   A British firm imports a machine priced at 30,000 euros. Calculate its cost in pounds when the rate is 1 pound = 1.20 euros and again after sterling falls to 1 pound = 1.00 euro, and state the percentage increase in cost.

   Model answer

   At 1.20 euros to the pound the machine costs 30,000 divided by 1.20 = 25,000 pounds. At 1.00 euro to the pound it costs 30,000 divided by 1.00 = 30,000 pounds. The increase is 5,000 pounds, which is 5,000 divided by 25,000 = 0.20, or 20%, so a fall in sterling raises the domestic cost of imported capital equipment and squeezes the firm's margins or forces it to raise its own prices.

6. 6

   What is an effective or trade-weighted exchange rate, and why is it more useful than a single bilateral rate?

   Model answer

   An effective exchange rate is an index of a currency’s value against a basket of the currencies of its main trading partners, with each currency weighted according to its share in that country’s trade. It is more useful than a single rate because a currency can rise against one partner while falling against another, so a bilateral rate can give a completely misleading impression of overall competitiveness. The index summarises the net effect on the prices faced by the country’s exporters and importers as a whole.

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