In this lesson summary review and remind yourself of the key terms and calculations related to exchange rates.
Lesson summary
If someone from Hamsterville came up to you and tried to buy an old book from you, and tried to pay you in their currency — the Hamsterville snark () — you’d tell them “no thanks!”
Why? Because the Hamsterville snark is worthless to you since you can’t buy anything with it in your country. Instead, you want to be paid in your own currency. That means that someone from Hamsterville would need to exchange their currency for the currency used in your country.
The exchange rate of a currency is how much of one currency can be bought for each unit of another currency. A currency appreciates if it takes more of another currency to buy it, and depreciates if it takes less of another currency to buy it.
Key terms
| Key term | Definition |
|---|
| exchange rate | the price of one currency in terms of another currency; for example, if the exchange rate for the euro (€) is yen (¥), that means that each Euro that is purchased will cost yen. |
| appreciate | when a currency becomes more valuable relative to another currency; a currency appreciates when you need more of another currency to buy a single unit of a currency. |
| depreciate | when the value of a currency decreases relative to another currency; a currency depreciates when you need less of another currency to buy a single unit of a currency. |
| floating exchange rates | when the exchange rates of currencies are determined in free markets by the interaction of supply and demand |
Key takeaways
The exchange rate is the price of one currency in terms of the other
Currencies are traded in the foreign exchange market. Like any other market, when something is exchanged there is a price. In the foreign exchange market, a currency is being bought and sold, and the price of that currency is given in some other currency. That price is expressed as an exchange rate.
For example, in the market for the Hamsterville snark, the exchange rate of the snark to the U.S. dollar () is per snark. That means in order to buy a single snark, someone from the United States would need to pay for it with .
On the other hand, someone from Hamsterville who wants dollars would buy those dollars with snarks. So, the exchange rate of the dollar is the inverse of the exchange rate of the snark:
Sophie is a reporter for the Hamsterville Courier News and is preparing an article on the exchange rates for three of Hamsterville’s primary trading partners. Unfortunately, she spilled her lime smoothie on her notes and some of the entries in the table she created are missing. Help her out by completing the missing entries in the table below:
| Hamsterville snark () | Galactic credits () | Canadian dollar () |
|---|
| 1 Hamsterville snark (SN) is exchanged for | 1 | 10 | 2 |
| 1 Galactic credit (GC) is exchanged for | | 1 | .2 |
| 1 Canadian dollar () is exchanged for | | | 1 |
Solution:Remember that the exchange rates of any two currencies are inverses of each other. So, if the exchange rate for the Hamsterville snark (SN) is:
Then the inverse of that exchange rate is the exchange rate for the galactic credit (GC):
| Hamsterville snark () | Galactic credits () | Canadian dollar () |
|---|
| 1 Hamsterville snark (SN) is exchanged for | 1 | 10 | 2 |
| 1 Galactic credit (GC) is exchanged for | .1 | 1 | .2 |
| 1 Canadian dollar () is exchanged for | 0.5 | 5 | 1 |
If a currency appreciates it is more valuable; if a currency depreciates it is less valuable
When an exchange rate changes, the value of one currency will go up while the value of the other currency will go down. When the value of a currency increases, it is said to have appreciated. On the other hand, when the value of a currency decreases, it is said to have depreciated.
For example, if it now takes to buy a single Hamsterville snark instead of , the snark has appreciated and its value has increased. If prices in the United States haven’t changed, this is great news for Hamstervillians! Now the snark can buy more goods and services from the United States.
But, this is bad news for Americans who want to buy Hamsterville’s goods and services. Each U.S. dollar now buys only instead of as it did before. The dollar has depreciated against the snark and everything from Hamsterville just got a lot more expensive.
Key equations
Exchange rates
The exchange rate of a currency is expressed as the units of another currency needed to buy a single unit of the currency. For example, the exchange rate for currency A is given below:
Calculating the cost of something with exchange rates
To find the cost of something in the value of another currency, divide that cost by the exchange rate. For example, it takes 300 galactic credits () to buy a smoothie on Tatooine. If the exchange rate means that buys , then the cost of a Tatooine smoothie to a Canadian tourist is:
Therefore a Tatooine smoothie costs to a Canadian.
Common misperceptions
We are used to thinking about buying things with a currency, so many new learners are confused about what the price should be in the market for a currency. But the price of an orange is never given in oranges; it’s given in some other currency. Just like an orange, a dollar can’t be bought with itself, but instead, it needs to be bought with some other currency.
A common misperception is that a strong currency is always what is best for a country. On the one hand, if a currency appreciates, all of its imported goods get a lot cheaper. If a country tends to import a lot more goods than they export, then an appreciated currency might be desirable. But on the other hand, if a country relies heavily on exports, an appreciating currency isn’t such a great thing. When a currency appreciates, the exports from a country that use that currency will decrease because all of those goods are more expensive to countries other currencies.
Questions for review
The Ghanaian cedi currently trades for 20 Icelandic kroné.
- What is the exchange rate of the kroné? What is the exchange rate for the cedi? SHOW YOUR WORK.
- If the trading price changes to 25 kroné per cedi, what has happened to:
- If the cost of a fermented shark sandwich in Iceland is 1500 kroné, what is its cost in cedi to a tourist from Ghana based on a trading price of 1 cedi for 20 kroné? Show your work.
ééé
Remember that exchange rates are always expressed as the amount needed to buy a single unit of the currency described.
é
If the trading price changes to 1 cedi for 25 kroneThe kroné has depreciated. A single cedi can now buy more kroné, so the kroné is cheaper.
b. The cedi has appreciated. A single cedi can buy more of the other currency (the kroné), so the cedi is more valuable.
You need 75 cedi to buy a shark sandwich.
FAQs
An exchange rate is a rate at which one currency will be exchanged for another currency. While most exchange rates are floating and will rise or fall based on the supply and demand in the market, some exchange rates are pegged or fixed to the value of a specific country's currency.
How do you solve exchange rate questions? ›
Using the exchange rate we can convert between pounds and foreign currencies. To do this we need to either multiply or divide the quantity we are trying to convert with the exchange rate. To convert from British pounds to a foreign currency you must multiply by the exchange rate. So 150 £150 would be 276 $276 because.
What is the lesson of exchange rate? ›
The exchange rate of a currency is how much of one currency can be bought for each unit of another currency. A currency appreciates if it takes more of another currency to buy it, and depreciates if it takes less of another currency to buy it.
How do foreign exchange rates work? ›
In a floating regime, exchange rates are generally determined by the market forces of supply and demand for foreign exchange. For many years, floating exchange rates have been the regime used by the world's major currencies – that is, the US dollar, the euro area's euro, the Japanese yen and the UK pound sterling.
What are the important concepts of exchange rates? ›
An exchange rate is the rate at which one currency can be exchanged for another between nations or economic zones. It is used to determine the value of various currencies in relation to each other and is important in determining trade and capital flow dynamics.
What does the exchange rate tell us about the economy? ›
Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country's relative level of economic health. A higher-valued currency makes a country's imports less expensive and its exports more expensive in foreign markets.
How do you solve exchange rates? ›
If you don't know the exchange rate, you can use the following simple currency conversion calculation to find it: take your starting amount (original currency) and divide it by ending amount (new currency) = exchange rate.
What is the math behind the exchange rate? ›
If you know the exchange rate, divide your current currency by the exchange rate. For example, suppose that the USD/EUR exchange rate is 0.631 and you'd like to convert 100 USD into EUR. To accomplish this, simply multiply the 100 by 0.631 and the result is the number of EUR that you will receive: 63.10 EUR.
What is a simple formula to understand exchange rate? ›
Know the country's exchange rate before you travel – these are usually posted online and at banks, airports and currency exchange shops. If you don't know the exchange rate, you can use this formula: starting amount (base currency) / ending amount (foreign currency) = exchange rate.
Why is it important to know exchange rates? ›
Changes in export and import prices arising from a change in the exchange rate mainly influence demand for goods and services that are exported and imported (these are known as tradablegoods and services). But exchange rate movements also have implications for the demand for non-tradable goods and services.
The real exchange rate (RER) between two currencies is the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries.
What makes a dollar strong? ›
The dollar strengthens when interest rates rise, and international investors view it as a safe haven for maintaining and increasing value during turbulent economic times. In general, the strength and value of a currency depends on the demand for that currency. The dollar will strengthen when demand for it strengthens.
What is the strongest currency in the world? ›
The Kuwaiti dinar (KWD) is the world's strongest currency, and this is for a number of reasons. For starters, Kuwait has one of the largest oil reserves in the world.
Which currency has the highest value? ›
1. Kuwaiti Dinar, Highest Currency in the World. Kuwaiti Dinar holds the reputation of being the strongest currency in the world. Abbreviated to KWD, Kuwaiti Dinar is commonly used in oil based transactions in Middle East.
How to make currency stronger? ›
Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency.
What is the exchange rate in simple words? ›
Definition: Exchange rate is the price of one currency in terms of another currency. Description: Exchange rates can be either fixed or floating. Fixed exchange rates are decided by central banks of a country whereas floating exchange rates are decided by the mechanism of market demand and supply.
What is the effective exchange rate in simple words? ›
The effective exchange rate is an index that describes the strength of a currency relative to a basket of other currencies. Typically it is calculated using geometric weighting. It can be computed using the USD as a numeraire.
What is the real exchange rate simplified? ›
What is the real exchange rate? The real exchange rate (RER) between two currencies is the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries.
What is the significance of the exchange rate? ›
Movements in the exchange rate influence the decisions of individuals, businesses and the government. Collectively, this affects economic activity, inflation and the balance of payments. There are different ways in which exchange rates are measured.
