Introduction to Exchange Rates

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The Importance of Currency Markets

In virtually all modern economies, money (i.e. currency) is created and controlled by a central governing authority. In most cases, currencies are developed by individual countries, though this need not be the case. (One notable exception is the Euro, which is the official currency for most of Europe.) Because countries buy goods and services from other countries (and sell goods and service to other countries), it's important to think about how currencies of one country can be exchanged for currencies of other countries.

Like other markets, foreign-exchange markets are governed by the forces of supply and demand. In such markets, the "price" of a unit of currency is the amount of another currency that is needed to purchase it. For example, the price of one Euro is, as of the time of writing, about 1.25 US dollars, since currency markets will exchange one Euro for 1.25 US dollars.

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Exchange Rates

These currency prices are referred to as exchange rates. More specifically, these prices are nominal exchange rates (not to be confused with real exchange rates). Just as the price of a good or service can be given in dollars, in Euro, or in any other currency, an exchange rate for a currency can be stated relative to any other currency. You can see a variety of such exchange rates by going to various finance websites.

A US Dollar/Euro (USD/EUR) exchange rate, for example, gives the number of US dollars than can be bought with one Euro, or the number of US dollars per Euro. In this way, exchange rates have a numerator and a denominator, and the exchange rate represents how much numerator currency can be exchanged for one unit of denominator currency.

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Appreciation and Deprecation

Changes in the price of a currency are referred to as appreciation and depreciation. Appreciation occurs when a currency becomes more valuable (i.e. more expensive), and depreciation occurs when a currency becomes less valuable (i.e. less expensive). Because currency prices are stated relative to another currency, economists say that currencies appreciate and depreciate specifically relative to other currencies.

Appreciation and depreciation can be inferred directly from exchange rates. For example, If the USD/EUR exchange rate were to go from 1.25 to 1.5, the Euro would buy more US dollars than it did before. Therefore, the Euro would appreciate relative to the US dollar. In general, if an exchange rate increases, the currency in the denominator (bottom) of the exchange rate appreciates relative to the currency in the numerator (top).

Similarly, if an exchange rate decreases, the currency in the denominator of the exchange rate depreciates relative to the currency in the numerator. This concept can be a little tricky since it's easy to get backward, but it makes sense: for example, if the USD/EUR exchange rate were to go from 2 to 1.5, a Euro buys 1.5 US dollars rather than 2 US dollars. The Euro, therefore, depreciates relative to the US dollar, since a Euro doesn't trade for as many US dollars as it used to.

Sometimes currencies are said to strengthen and weaken rather than appreciate and depreciate, but the underlying meanings of and intuitions for the terms are the same,

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Exchange Rates as Reciprocals

From a mathematical perspective, it's clear that a EUR/USD exchange rate, for example, should be the reciprocal of a USD/EUR exchange rate, since the former is the number of Euro that one US dollar can buy (Euro per US dollar), and the latter is the number is US dollars that one Euro can buy (US dollars per Euro). Hypothetically, if one Euro buys 1.25 = 5/4 US dollars, then one US dollar buys 4/5 = 0.8 Euro.

One implication of this observation is that when one currency appreciates relative to another currency, the other currency depreciates, and vice versa. To see this, let's consider an example where the USD/EUR exchange rate goes from 2 to 1.25 (5/4). Because this exchange rate decreased, we know that the Euro depreciated. We can also say, because of the reciprocal relationship between exchange rates, that the EUR/USD exchange rate went from 0.5 (1/2) to 0.8 (4/5). Because this exchange rate increased, we know that the US dollar appreciated relative to the Euro.

It's very important to understand precisely what exchange rate you are looking at since the way that the rates are stated can make a big difference! It's also important to know whether you are talking about nominal exchange rates, as introduced here, or real exchange rates, which state directly how much of one country's goods can be traded for a unit of another country's goods.