Exchange rates
Key terms
Define each term.
Multiple choice
Circle the correct answer.
A country's currency depreciates. Which is the most likely immediate effect?
Which would increase demand for a country's currency on the foreign exchange market?
Worked problems
Show your working.
What an appreciation does to importers and exporters. A currency appreciates from $1 = 4 pesos to $1 = 5 pesos. A domestic exporter sells a machine for 20,000 pesos. An importer buys components priced at $6,000. Calculate the effect on each, and state who gains.
Diagrams
Draw a foreign exchange market diagram with the exchange rate on the vertical axis and quantity of the currency on the horizontal axis. Show demand and supply meeting at an equilibrium rate. Then show separately the effect of a rise in exports, and the effect of a rise in domestic interest rates attracting foreign investment.
Answers
Exchange rate: The price of one currency expressed in terms of another.
Floating exchange rate: An exchange rate determined by the demand for and supply of the currency on the foreign exchange market, without government intervention to fix its value.
B. A weaker currency means foreigners need less of their own money to buy a given amount of it, so exports priced in the domestic currency become cheaper to them. Domestic buyers need more of their own currency to obtain foreign currency, so imports become dearer. This is SPICED read in reverse.
B. Foreign buyers of exports must obtain the domestic currency to pay for them, which raises demand for it. The other three all involve domestic residents needing foreign currency, so they supply the domestic currency to the market and push its value down.
Step 1. Read the rate change correctly. Each dollar now buys 5 pesos rather than 4, so the dollar has appreciated against the peso. Equivalently, the peso has depreciated: it was worth $0.25 and is now worth $0.20.
Step 2. Calculate the export price in dollars, before and after. Before: 20,000 / 4 = $5,000. After: 20,000 / 5 = $4,000. The machine is $1,000 cheaper to a dollar-paying buyer, so peso exports have become more competitive.
Step 3. Calculate the import cost in pesos, before and after. Before: $6,000 x 4 = 24,000 pesos. After: $6,000 x 5 = 30,000 pesos. The components cost 6,000 pesos more, so imports have become dearer for the peso economy.
Step 4. State who gains and who loses. From the peso economy's point of view its currency has depreciated: exporters gain because their goods are cheaper abroad, and importers lose because foreign goods cost more. From the dollar economy's point of view the reverse holds. Every exchange rate movement helps one side of each economy and harms the other.
Step 5. Remember the mnemonic and its limits. SPICED captures it: Strong Pound, Imports Cheap, Exports Dear. It works for any currency. But it describes prices only. Whether the trade balance actually improves depends on how much quantities respond, which is a separate question.
Always state which currency you are viewing the change from. The same movement is an appreciation for one country and a depreciation for the other, and answers that do not fix a viewpoint contradict themselves halfway through.
Both shocks shift demand right and appreciate the currency, but for different reasons, and questions expect the reason rather than just the direction. Label the vertical axis with actual units, such as dollars per peso, because 'exchange rate' alone leaves it ambiguous which way an increase means the currency has moved.