Foreign Exchange Rates

Most common contact with foreign exchange occurs;

When we travel or buy things in other countries.

It would seem logical that if the dollar weakens, the trade balance will improve, as exports would rise. However, this does not always happen. U.S. trade balance usually worsens for a few months.

The J–curve explains why the trade position does not improve soon after the weakening of a currency. Most import/export orders are taken months in advance. Immediately after a currency’s value drops, the volume of imports remains about the same, but the prices in terms of the home currency rise. On the other hand, the value of the domestic exports remains the same, and the difference in values worsens the trade balance until the imports and exports adjust to the new exchange rates.

Exchange rates are an important consideration when making international investment decisions. The money invested overseas incurs an exchange rate risk.

When an investor decides to "cash out," or bring his money home, any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. Thus, changes in exchange rates can have many repercussions on an economy:

* Affects the prices of imported goods
* Affects the overall level of price and wage inflation
* Influences tourism patterns
* May influence consumers’ buying decisions and investors’ long-term commitments.


Suppose a U.S. tourist travelling in London wants to buy a sweater.

Price tag is 100 pounds.

Current exchange Price of sweater in
rate dollars
$1.45 to £1 100 x 1.45 = $145.00
$1.30 to £1 Pound falls 100 x 1.30 = $130.00
$1.60 to £1 Pound rises 100 x 1.60 = $160.00

Thus, small changes in exchange rates may not seem significant. But when billions of dollars are traded, even a hundredth of a percentage point change in exchange rates becomes important.

Stronger US dollar implies;

1. U.S. can buy foreign goods more cheaply ------Cost of purchasing foreign goods falls

2. Foreigners find U.S. goods more expensive and demand falls -----Does not help firms that produce for exports

Weaker U.S. dollar implies;

1. Foreigners buy more U.S. goods -------Helps firms that rely on exports

2. Foreign goods become more expensive ------Demand for imports falls