# A Primer on Exchange Rates and Exporting WASHINGTON STATE UNIVERSITY EXTENSION EM041E

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1 A Primer on Exchange Rates and Exporting WASHINGTON STATE UNIVERSITY EXTENSION EM041E

3 transaction must then be used to buy U.S. dollars in the second transaction. Figure 1. Market for goods and services in the foreign country. Twenty units of goods and services (horizontal axis) are being bought and sold at a price (vertical axis) of 12.5 pesos per unit. vertical axis. Because Figure 1 illustrates the market for goods in Mexico, the price per unit of goods is shown in Mexican pesos. Figure 1 also shows the upward sloping supply curve and the downward sloping demand curve for the Mexican goods market. The intersection of these two slopes is the equilibrium point. This point is the quantity of the good that is traded and the price per unit of the trade. In this figure, 20 units of the good are bought and sold at a price of 12.5 Mexican pesos per unit. Note that the location of the seller is unimportant, since the buyer will purchase the goods using pesos whether or not the seller is in Mexico or in the United States. Now consider the foreign exchange market (Figure 2). Suppose the Mexican buyer purchases the good or service from a U.S. seller. The Mexican pesos used in the first purchasing The horizontal axis in Figure 2 shows the amount of the good being purchased, and the vertical axis shows the price of the good being purchased. In this example, pesos are being used to purchase dollars, so the quantity or number of dollars is shown on the horizontal axis, and the price (in pesos) per dollar is shown on the vertical axis. The foreign exchange market functions the same way the market for goods and services does. There is an upward sloping supply curve of dollars with various prices (in pesos) per dollar, and there is a downward sloping demand curve of dollars with various prices (in pesos) per dollar. The intersecting point of these two slopes is the equilibrium point, and this point indicates the number of dollars traded and the price (in pesos) for each dollar. To see that the foreign exchange market functions in the same way the market for goods and services does, notice that the equilibrium point is the same in Figure 1 and Figure 2. In Figure 2 then, a total of 20 dollars is being sold at a price or rate of 12.5 pesos per dollar. Why Foreign Exchange Prices Change Changes in price and quantity affect market volatility but so do other changing factors, such as nationwide income levels, population sizes and preferences, costs of overall production, technology used in overall production as well as factors like droughts, floods, and other natural disasters. When one or more of these factors changes, the market responds by setting a new point of equilibrium. Any factors that change the demand for a country s currency (other than the exchange rate itself) will shift the demand curve and create a new point of equilibrium. Conversely, any factors that change the supply of currency will shift the supply curve and create a new point of equilibrium as well. Both Figure 1 and Figure 3 show the same market for goods and services in Mexico, but the market in Figure 3 has responded to a change, (e.g., a change in preferences or an increase in buyers incomes), with an outward shift of the demand curve. This shift results in a new point of equilibrium in which more goods or services are bought or sold at a higher price (in pesos). Figure 2. Foreign exchange market. Dollars (horizontal axis) are being bought and sold at a price (vertical axis) of 12.5 pesos per dollar. Figure 3 illustrates one source of uncertainty, but outside events can change the price established by the market for goods and services, and both foreign (U.S.) and domestic (Mexican) sellers are subject to this uncertainty. Figure 4 shows the same foreign exchange market as seen in Figure 2, but the market has responded to an outward shift of the demand 3

4 large or rare events like natural disasters or changes in population size or makeup. Rather, these shifts are due to current market news and speculation that precipitate a change in expectations regarding the value of currency in the future. Changes in the expectation of future exchange rates can shift the demand and supply curves suddenly and frequently, causing a change in exchange rates in the present. (International traders can avoid the risk of exchange rate fluctuations with financial instruments; however, a description of these instruments is outside the scope of this discussion.) Figure 3. Market for goods and services in the foreign country with an outward shift of the demand curve. There is a new equilibrium with more units of goods and services bought and sold and an increase in price from 12.5 to 14.0 pesos per unit. Figure 4. Foreign exchange market with an outward shift of the demand curve. There is a new equilibrium with more units of dollars bought and sold and an increase in price from 12.5 to 14.0 pesos per dollar. curve for dollars. The result of this shift is that more dollars are being bought and sold at a higher price (in pesos). Figure 4 illustrates a second source of uncertainty for the foreign (U.S.) seller, since outside events can shift the exchange rate (price per dollar), whereas domestic (Mexican) sellers do not have this uncertainty. The equilibrium value of the exchange rate changes constantly throughout a given day, which means that either the supply or demand curves (or both) shift many times throughout the day. The frequency of these shifts means that they are not caused by The implication of these market movements for U.S. sellers is that revenue from foreign sales is affected by both the market for goods and services and the foreign exchange market, making the U.S. (foreign) sales revenue more volatile than the sales revenue of the Mexican (domestic) seller. However, it also means that if outside events affect the foreign exchange market without affecting the market for goods and services, a Mexican buyer may perceive the U.S. (foreign) seller s good to be cheaper than that of the Mexican (domestic) seller. On the other hand, outside events in the foreign exchange market could make the U.S. seller s good appear to be more expensive than that of the Mexican seller. Consider a real-world example in which a European buyer is planning to purchase 10,000 units of a good produced by an American firm or a French firm. Both the American and French firms initially charge one euro for each unit of the good. On June 8, 2011, each euro could buy \$1.46 (and each dollar could buy.68 euro), but by June 16, each euro could buy only \$1.41 (and each dollar could buy.71 euro). Thus between June 8 and June 16, the U.S. dollar appreciated. The American firm would have received \$14,600 for the sale on June 8 but only \$14,100 on June 16. In order for the American firm to maintain a profit margin, it would have to increase its price from one euro to euros. However, this price increase makes the good from the American firm more expensive than the good from the French firm, thus making the American firm less competitive. Appreciation, Depreciation, and their Relevance for Exports Appreciation is when each unit of a domestic currency can buy more units of a foreign currency than it could before, which means that the price of the foreign currency decreases. A domestic currency that can purchase more foreign currency over a sustained period of time is known as a strong currency. Depreciation is when each unit of domestic currency buys less of a foreign currency than it 4

7 peso. (Note that, as with Canada, there was a sharp jump in appreciation in 2009.) Japan is one of Washington state s biggest trading partners, and although the U.S. dollar has fluctuated, the overall trend with the nominal exchange rate has been a depreciation of the U.S. dollar relative to the Japanese yen. The real exchange rate also has had periods of fluctuation, but the overall trend has been roughly constant (Figure 8). (Unlike the Mexican peso and Canadian dollar, the Japanese yen did not experience a jump in appreciation in 2009.) Figure 6. Real and nominal exchange rate between the Canadian dollar and the U.S. dollar. Source: Author s compilation using data located at appreciated and was strong throughout the 1990s, but recently it has depreciated, meaning U.S. goods and services are now somewhat cheaper in Canada than they were previously. Figure 7 shows the exchange rate between the Mexican peso and the U.S. dollar (since Mexico revalued its currency in 1993, data is not plotted prior to this year.) 1 Unlike Canada, Mexico shows a big difference in its nominal and real exchange rates because it experienced high inflation in the 1990s. If only the nominal exchange rate is considered, then the U.S. dollar appears to have appreciated in the same period. However, the real exchange rate tells another story. This rate shows that the U.S. dollar actually depreciated against the inflation-adjusted Figure 7. Real and nominal exchange rate between the Mexican peso and the U.S. dollar. Source: Author s compilation using data located at 1 Currency revaluation occurs when a country eliminates zeros. For example, a 1000 peso note becomes a one peso note. Figure 8. Real and nominal exchange rate between the Japanese yen and the U.S. dollar. Source: Author s compilation using data located at Figure 9 shows the exchange rate between the U.S. dollar and the Chinese yuan. Compared to the other exchange rates, the rate between the U.S. and China is not volatile because China fixes its nominal exchange rate with the United States. Between 1996 and 2005, the nominal exchange rate between China and the U.S. was constant, and the real exchange rate appreciated due to somewhat higher inflation in China. In 2005, the Chinese government announced that it would let the exchange rate float to some degree. Figure 9 shows that in allowing the exchange rate to float, the U.S. dollar depreciated, which indicates that the Chinese were fixing the exchange rate above the equilibrium exchange rate. To accomplish this, the Chinese government had to buy large reserves of U.S. dollars. The Chinese government fixed the exchange rate again from 2008 to 2010 but at a lower rate than before, although this new fixed exchange rate was still above the equilibrium rate. Recently, the Chinese government has allowed the dollar to depreciate once again, but they have used currency intervention to ensure that depreciation of the dollar does not move too quickly. 7

8 rate also means that U.S. exporters are not getting the benefit of depreciation in China that they get in other countries. The final lesson is that better export decisions, in particular, decisions regarding competitive and profitable pricing in overseas markets can be achieved by understanding how the movement of exchange rates affect prices in domestic and foreign markets. Figure 9. Real and nominal exchange rate between the Chinese yuan and the U.S. dollar. Source: Author s compilation using data located at Figure 10 shows the trade-weighted currency index for the U.S. dollar. This index was arbitrarily constructed so that the exchange rate would be 100 in The purpose of doing this was to determine the trend in the data over time relative to the 2005 benchmark. The trade-weighted index contains a basket of world currencies, including currencies from Canada, Mexico, Japan, and China, and it also prominently features the euro and the British pound. Figure 10 confirms the trends we have previously discussed, namely, the depreciation of the U.S. dollar since 2002 and the 2009 jump in appreciation. The theory, data, and trends presented in this primer offer important lessons for Washington state business owners. The main lesson, seen in almost all the figures but best seen in Figure 10, is that the U.S. dollar has been weakening since This depreciation of the dollar is an advantage to U.S. firms that sell abroad because it makes U.S. goods somewhat cheaper in foreign markets. Another lesson is that as long as China keeps its currency at a fixed exchange rate, there will be little risk of exchange rate volatility for either buyers or sellers. However, China s fixed exchange Figure 10. Trade-weighted currency index centered so that 2005 = 100. Source: Author s compilation using data from the U.S Federal Reserve. 8

9 By Andrew J. Cassey and Pavan Dhanireddy, Washington State University School of Economic Sciences. Copyright 2011 Washington State University WSU Extension bulletins contain material written and produced for public distribution. Alternate formats of our educational materials are available upon request for persons with disabilities. Please contact Washington State University Extension for more information. You may order copies of this and other publications from WSU Extension at or wsu.edu. Issued by Washington State University Extension and the U.S. Department of Agriculture in furtherance of the Acts of May 8 and June 30, Extension programs and policies are consistent with federal and state laws and regulations on nondiscrimination regarding race, sex, religion, age, color, creed, and national or ethnic origin; physical, mental, or sensory disability; marital status or sexual orientation; and status as a Vietnam-era or disabled veteran. Evidence of noncompliance may be reported through your local WSU Extension office. Trade names have been used to simplify information; no endorsement is intended. Published October EM041E

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