Exchange Rates and Exchange: How Money Affects Trade
This lesson printed from:
Posted October 8, 2002
Author: Lisa C. Herman-Ellison
Posted: October 8, 2002
Updated: November 5, 2007
Students learn how currency values are set by supply and demand, and how changes in the value of currency affect international trade. Students then find the value of the Brazilian Real in 2000 and 2002, determine whether the currency has appreciated or depreciated, and predict the effects on imports and exports.
- Calculate prices of goods produced in other countries, given exchange rates.
- Predict the effect of changes in relative currency values on prices, demand for imports and exports, demand for currency, and trade deficits/surpluses.
- Explain why importers and exporters prefer strong or weak dollars.
In June 1998, the U.S. stepped into the foreign currency market, using billions of U.S. dollars to buy Japanese yen in an attempt to stabilize its value. Mexico faced a currency crisis in 1994. Argentina faced such a crisis in 2002. Why should we care about currency values of other nations?
How do currency values affect us, the demand for the products we produce, and the prices of the products we buy?
When people in one country demand products from firms in another country, they must enter into another market first, to buy that nation’s currency. For example, if you were employed as the merchandise buyer for a retail consumer electronics firm and wanted to buy Sony CD players to sell to your customers, you would not simply send a check to Sony in the amount of American dollars. Firms want to deal in their own currencies. As a result, you would have to go into the foreign exchange market to buy yen, which you could then use to pay Sony for the CD players.
In the same way that supply and demand for products shift to change the prices of those products, the constant shifts in the supply and demand for foreign currency result in changing prices of currency. As a result, the “price” of money changes as demand for foreign currencies changes. This “price” of foreign currency, in terms of U.S. currency, is known as the foreign exchange rate. It simply tells you how many American dollars it will cost you to purchase a unit of foreign currency. This “floating” foreign exchange rate changes daily with the international supply and demand for currency.
A number of factors can increase demand for a foreign currency. If the other nation’s products sell at a lower price than domestic products, consumers will increase their demand for imports. If domestic incomes rise or domestic inflation rates are higher than those in other nations, demand for imports will rise, as well. In capital markets, if another nation’s interest rate (return on investment) is higher than the domestic interest rate, some people will choose to invest in the other nation’s securities. When consumers import more products from a country or invest in that country’s securities, their demand for that currency increases. This increase in demand pushes the price of the currency higher, so their currency appreciates (rises in value).
Because consumers use U.S. dollars to buy the foreign currency, when the demand for foreign currency increases, the international supply of U.S. dollars increases proportionately. As the supply of dollars increases, the “price” of U.S. dollars falls, causing the dollar to depreciate (fall in value).
In the international market today, the supply and demand for currencies and the resulting relative values of currencies can affect the demand for imports and exports. For example, if we have a strong dollar, the dollar is very valuable compared to other currencies; other currencies appear very inexpensive to us. Because we can buy the currency more cheaply, the prices of the country’s products appear lower to us. And at lower prices, quantity demanded rises. So when the U.S. has a strong dollar, we buy more imports from foreign countries. This helps U.S. importers, such as electronics outlets, grocery stores, and gas stations, because when they can buy goods at a lower cost, they can offer those goods to their customers at lower prices, increasing the quantity demanded for their products and potentially increasing their profits.
An important negative effect of the strong dollar, however, exists for American exporters. When we have a strong dollar, buyers from other countries see our currency as being very expensive; they must give up more of their currency to buy dollars. As a result, the prices of our products appear more expensive to them. Therefore, the quantity demanded of our exports falls. This harms U.S. exporters, such as computer companies, auto manufacturers, and farmers, because they must lower their prices to try to attract demand for their products, resulting in lower profits and possibly forcing some firms out of business completely. The resulting impact of a strong dollar is a trade deficit. Imports rise, while exports fall.
The interesting thing about this entire phenomenon of changing exchange rates is that they can be self-correcting over time. For example, when we have a strong dollar, we demand more pesos to buy more Mexican products. But the very act of demanding more pesos causes the peso to appreciate, so Mexican imports appear to be more and more expensive over time. At the same time, the supply of U.S. dollars in the international market is growing, so their value falls as the dollar depreciates. Over time, imports are not as attractive, but our exports become more attractive to other countries, because their currency has become stronger. At that point, the U.S. would have a weak dollar--a condition, in which U.S. dollars are not very valuable compared to other currencies. Such a situation helps U.S. exporters, but hurts U.S. importers. This rise in exports and fall in imports results in a trade surplus. But over time, the situation can again reverse itself, as the increased foreign demand for U.S. exports forces up the prices of American goods internationally, so the quantity demanded by foreign countries again begins to fall.
In the cycle of international trade, changes in relative incomes, inflation rates, product prices, and interest rates can affect the international value of currencies. And at the same time, changes in the international value of currencies can affect the demand for products and securities in the international marketplace.
Answer the questions in this interactive activity.
To calculate exchange rates, begin with the equation of one currency equal to another. For example, the table below indicates that the price of a U.S. Dollar, in terms of British Pounds, is .70 Pounds; therefore, $1 = .70 Pounds, and 1 Pound = $1.43. You can then use that information to answer other questions. Use this exchange rate information from April 2002 to answer the questions below.
1 British Pound = $1.43 -- $1 = 0.70 British Pounds
1 Canadian Dollar = $0.63 -- $1 = 1.59 Canadian Dollars
1 Egyptian Pound = $0.22 -- $1 = 4.61 Egyptian Pounds
1 Russian Ruble = $0.03 -- $1 = 31.21 Russian Rubles
1 South African Rand = $0.09 -- $1 = 11.14 South African Rands
1 Swiss Franc = $0.60 -- $1 = 1.66 Swiss Francs
1. How much does it cost in American Dollars to buy one South African Rand?
2. How much does it cost in Russian Rubles to buy one American Dollar?
3. Suppose you wanted to buy a sculpture, and the price was 2000 Egyptian Pounds. How much would the sculpture cost in American Dollars?
[$440 (or $433.84 due to rounding.)]
4. Suppose you wanted to buy a watch, and the price was 50 Swiss Francs. How much would the watch cost in American Dollars?
[$30 (or $30.12 due to rounding.)]
5. If you planned a vacation to the United Kingdom and wanted to exchange your money before you left, how many British Pounds could you get for $1,000?
[700 Pounds (or 699.30 Pounds due to rounding.)]
6. Why do American business owners try to avoid accepting Canadian coins?
[Canadian money has a lower value than American money.]
1. Assume the United States develops a strong international dollar. Explain the effect of this strong dollar on each of the following; also explain why that effect would occur.
A. The price of Pakistani rugs.
[The price appears to fall, because the dollar can buy even more Pakistani currency.]
B. The amount of rugs imported from Pakistan.
[More rugs are imported, because the price of each rug appears to be lower.]
C. American demand for the Pakistani currency of Rupees.
[The demand for Pakistani currency rises, because we must buy Pakistani currency to buy Pakistani products.]
D. Profits of importers, such as Pier One Imports.
[Profits can increase, if the firms incur lower costs for the merchandise, but sell the product to customers at the same price as before the lower costs were incurred.]
E. The price of American machinery, to Pakistani retail firms.
[The price will appear to increase, because a stronger dollar makes Pakistani currency relatively weaker.]
F. The amount of American machinery exported to Pakistan.
[Exports will decrease, because the higher price reduces the quantity demanded.]
G. Pakistani demand for American Dollars.
[The demand for American dollars falls, because if demand for exports falls, there is less need for dollars to pay for those exports.]
H. The profits of exporters, such as American machinery producers.
[Profit can fall, if the demand for an exported product falls and the firm must lower prices.]
I. United States balance of trade (trade deficit or trade surplus?)
[As imports increase and exports decrease, a trade deficit develops.]
2. Assume that the United States dollar has depreciated in value. Explain the effects of this weak dollar on each of the following; and explain why that effect would occur.
A. American imports of foreign products.
[Imports will fall, because the prices of imports appear to have risen.]
B. American exports to foreign consumers.
[Exports will rise, because the price of exports appears to have fallen, to foreign consumers.]
C. United States balance of trade (trade deficit or trade surplus?)
[As imports decrease and exports increase, a trade surplus develops.]
3. Explain whether each of these people would prefer a strong or a weak dollar, and why.
A. A farmer.
[Farmers prefer a weak dollar, because it makes their crops appear less expensive to foreign consumers, increasing their demand for the farmer’s export.]
B. A line worker at an auto plant.
[Auto plant line workers prefer a weak dollar, because it makes their cars appear less expensive to foreign consumers, increasing their demand for the automaker’s export. In addition, a weak dollar makes imported cars appear more expensive, reducing American demand for foreign competitors’ cars.]
C. A gas station owner.
[Gas station owners prefer a strong dollar, because it makes their imported gas appear less expensive.]
D. A banana consumer.
[Banana consumers prefer a strong dollar, because it makes their imported bananas appear less expensive.]
4. Which of the following is more beneficial for the United States: a strong dollar, a weak dollar, both, or neither? Explain your answer.
[The strong and weak dollar can benefit different sectors of the economy. Import-dependent industries prefer a strong dollar, as it makes the prices of imports appear lower, so people will buy more. Export-dependent industries prefer a weak dollar, as it makes the prices of exports appear lower, so people will buy more.]
Go to the Currency Exchange Table
A. Put in the following information:
1. Based on this currency: USD = United States Dollars.
2. As of this date:
3. The following date: January 1, 2000.
B. Click “Generate Currency Table”.
1. Find Brazil Real, copy the number under “U.S.D/Unit”, and paste that number below. This number is the amount of U.S. dollars and cents required to purchase one Brazilian Real in 2000.
U.S.D/Unit in 2000: [.537634 Dollars]
2. Click “Back” in the toolbar, then replace “January 1, 2000” with “January 1, 2002”. Copy the number under “U.S.D/Unit” and paste that number below. This number is the amount of U.S. dollars and cents required to purchase one Brazilian Real in 2002.
U.S.D/Unit in 2002: [.431109 Dollars]
3. Has the United States Dollar appreciated (has Brazilian currency gotten less expensive?) or depreciated (has Brazilian currency gotten more expensive?) since 2000?
[The U.S. Dollar has appreciated.]
4. What effect did the appreciation of the United States Dollar have on the price of our imports from Brazil in 2002, compared to 2000?
[The price of imports appears to have dropped.]
5. Would that appreciation of the United States Dollar have led us to buy more or fewer imports from Brazil in 2002, compared to 2000?
[Because imports appear to be less expensive, imports will increase.]
6. Because the United States Dollar appreciated, has the Brazilian Real appreciated or depreciated in value since 2000?
[The Brazilian Real has depreciated.]
7. What effect did the depreciation of Brazilian currency have on the price Brazilians saw for exports from the United States in 2002, compared to 2000?
[The price of exports appears to have increased.]
8. Would that depreciation of the Brazilian currency have led Brazilian firms to buy more or fewer exports from the United States in 2002, compared to 2000?
[Because exports appear to be more expensive, exports will decrease.]
As supply and demand for currencies change, the values of those currencies change. When the U.S. dollar is strong, imports seem less expensive, leading to increased demand for imported products and the currency needed to purchase them. In addition, when interest rates in another nation are higher than those in the U.S., demand for the foreign currency rises, as people buy the currency in order to invest in the other nation’s securities. At the same time, a stronger dollar decreases exports, because they appear more expensive to foreign consumers. Therefore, a trade deficit develops as the result of a strong dollar. The opposite effects result from a weak U.S. dollar. While importers prefer a strong dollar, exporters prefer a weak dollar.
The differences in currency values can affect our ability to buy imports or sell exports, affecting our standard of living. Therefore, the effects of currency crises in other nations are not limited to those nations -- they can affect our economy and our lives in important ways.
1. What was the value of the Euro in terms of U.S. dollars as of January 1, 2000?
[$1.00530 = 1 Euro.]
2. What was the value of the Euro in terms of U.S. dollars as of January 1, 2002?
[$0.886322 = 1 Euro.]
3. Did the value of the U.S. dollar appreciate or depreciate against the Euro between 2000 and 2002?
[The U.S. dollar appreciated; while it cost U.S. purchasers approximately $1.01 to buy one Euro in 2000, it only cost U.S. purchasers only about 89 cents to buy one Euro in 2002.]
4. Name two factors that could explain why the demand for U.S. dollars increased, causing the change in the value of the dollar.
[Foreigners may have demanded more dollars to buy U.S. exports, or they may have demanded more dollars to invest in U.S. securities.]
5. How will the change in the value of the U.S. dollar affect imports from Europe and exports to Europe?
[Imports from Europe will increase, because the prices of products will appear lower; exports to Europe will decrease, because the prices of our products will appear higher to foreign customers.]
6. Will this change in imports and exports result in a trade surplus or a trade deficit with Europe?
[Increased imports and reduced exports result in a trade deficit.]