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 (
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 |
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 (
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 ( | 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:
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 ( | 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
But, this is bad news for Americans who want to buy Hamsterville’s goods and services. Each U.S. dollar now buys only
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 (
Therefore a Tatooine smoothie costs
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:
(a) the kroné? Explain.
(b) the cedi? Explain.
- 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.
You bet!
é é é
Remember that exchange rates are always expressed as the amount needed to buy a single unit of the currency described.
- a.
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.
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You need 75 cedi to buy a shark sandwich.