Question

Write a paragraph describing what excange rates are and how they impact the flow of goods and services in the world economy.

Answer 1

An exchange rate or currency exchange rate is the price (or cost) of one currency in termsof another currency. For example, an exchange rate quote of USD/EUR as 0.80 means 1 U.S. dollar equals 0.8 Euros. Simply put, we can 'exchange' 1USD and get 0.8 Euros.

Exchange rates affect flow of goods, services and capital among countries in the global economy because exchange rates may make good, service and capital more expensive or cheaper by altering the exchange rates.

If the exchange rate of a country appreciates, its exports become more expensive and its imports become cheaper.

Example: If currently 1 USD = 0.8 Euros and a merchant in US is buying (importing) machinery from Germany (which has Euro as its currency) that costs 800 Euros, the merchant in US pays 1000 USD and gets the machinery. If Euro appreciates against the dollar i.e. exchange rate becomes 1 USD = 0.7 Euros, the same machinery which costs 800 Euros will cost ~1143 USD [Calculation : (1 USD / 0.7 Euros) * 800 Euros = 1142.86 USD] and the merchant in US will need to pay more dollars to get the same machinery of 800 Euros.

The opposite is also true, if the Euro depreciates, for e.g. if USD/EUR = 0.9, the machinery would cost ~889 USD [Calculation : (1 USD / 0.9 Euros) * 800 Euros = 888.89 USD]and become cheaper for the merchant in U.S.

Countries use exchange rates to control their exports/imports and thus the flow of goods and services in the world economy.