SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 17)

How Exchange Rates Are Determined

by

Charles Lamson

There are three main causes that dispose men to madness: love, ambition, and the study of foreign exchange.

     ---Walter Leaf, 1926

How do changes in the international value of the dollar affect job opportunities for recent college graduates and other workers? How are domestic rates linked with interest rates in the rest of the world, and how are domestic prices affected by foreign prices? Perhaps, most importantly, how are all of these questions and their answers related?

Not long ago, such questions and the interactions between the U.S. economy and the rest of the world were largely ignored by most bankers, stock market analysts, economists, accountants, corporate treasurers, and policy makers. The reason was simple but twofold:

1. Trading of goods, services, financial claims (securities), and monies (currencies) between the United States and other countries accounted for only a small portion of total of transactions in the United States.
2. Exchange rates between currencies were fixed by the central banks of the various countries and did not change on a day-to-day basis.

Today, the value of the dollar relative to other currencies change daily and questions about its value are often puzzling to the average person. Many diverse opinions exist about whether a strong dollar is good or bad for the economy. Exchange rates are merely prices (the price of one currency in terms of another) that are determined in a market (the foreign exchange market). As in all markets, prices (foreign exchange rates) are ultimately determined by the forces of supply and demand.

Defining Exchange Rates

The exchange rate is the number of units of foreign currency (money) that can be acquired with one unit of domestic money. In other words, the exchange rate specifies the purchasing power of say the dollar in terms of how much it can buy of another currency. For example, if the yen/dollar exchange rate is 100 yen, this literally means that $1 will buy 100 yen. If the exchange rate rises to 150 yen, then the dollar is said to have appreciated relative to the yen. Since it will now buy more yen, the dollar's purchasing power has risen. It has grown stronger. On the other hand, if the yen/dollar exchange rate falls from 100 yen to 50 yen, the dollar is said to have depreciated relative to the yen. Since it will now buy fewer yen, the dollar's purchasing power has fallen. It has grown weaker. Supplies of foreign currencies are called foreign exchange.

So what does all of this have to do with the price a U.S. importer will have to pay for Japanese autos? The following handy formula, linking prices and the exchange rate, provides the ingredients necessary to answer the question:

(1) U.S. dollar price of foreign goods = foreign price of foreign goods/exchange rate

The accompanying Cracking the Code section below uses this formula and the hypothetical figures already mentioned to illustrate the key point of this discussion---the U.S. dollar price of a foreign good is inversely related to the exchange rate. More specifically, as the dollar appreciates, ceteris paribus, the price of foreign goods in the United States falls, even if the foreign price in yen is constant. Conversely, as the dollar depreciates, ceteris paribus, the price of foreign goods in the United States rises.

CRACKING THE CODE

How Movements in the Exchange Rate Affect the Dollar Price of Foreign Goods

Suppose a Japanese auto costs 2 million yen in Japan. Ignoring transportation costs and the like, what will it cost in the United States? The answer is that the price depends on the exchange rate between the yen and the dollar. The middle row in the following table lists the beginning situation: If the auto costs 2 million yen and $1 buys 100 yen, then as equation 1 indicates, the dollar price will be $20,000 (2,000,000/100).

The top row in the table shows that when the dollar appreciates from 100 yen to 150 yen, the dollar price of the Japanese auto falls to $13,333 (2,000,000/150). In contrast, as illustrated in the third row a depreciation of the dollar results in a rise in the dollar price of the Japanese auto.

Yen Price of Japanese Auto (1)	Exchange Rate (2)	Dollar Price of Japanese Auto (1)(2)
2,000,000 yen	$1 = 150 yen	$13,333
2,000,000 yen	$1 = 100 yen	$20,000
2,000,000 yen	$1 = 50 yen	$40,000

Recap

The exchange rate is the number of units of foreign currency that can be acquired with one unit of domestic money. The U.S. dollar price of foreign goods is equal to the foreign price of foreign goods divided by the exchange rate.

*SOURCE: SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 196-197*

END

Yen Price of Japanese Auto

(1)

Exchange Rate

(2)

Dollar Price of Japanese Auto

(1)(2)

2,000,000 yen

$1 = 150 yen

$13,333

2,000,000 yen

$1 = 100 yen

$20,000

2,000,000 yen

$1 = 50 yen

$40,000