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Economics: Nominal Exchange Rates


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About this Lesson

  • Type: Video Tutorial
  • Length: 11:33
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 123 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: International Focus (25 lessons, $43.56)
Economics: Exchange Rates (6 lessons, $12.87)

In this video lesson on economics, you'll learn about nominal exchange rates. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

About this Author

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A mystery -- no more!
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A mystery -- no more!
~ Vincent14

Excellent -- It was always a mystery to me - not anymore

Thank you -- The instructor was excellent as well.

Suppose you're in Mexico City and you want to buy a bottle of water. At the store, you'll see a sign posted that says, "A bottle of water costs 20 pesos," but you've got US dollars, because you're traveling on vacation from California. The first thing you have to do is trade your US dollars for Mexican pesos to spend in the store. And the exchange rate at which you can do that at the American Express office or at the airport is $2.00 US equals 20 pesos. Get your 20 pesos, take them to the store and then buy your water. What you've just done is a combination transaction. You did a purchase of a good and service in Mexico, but first you had to get the local currency, so you did a foreign exchange transaction.
Foreign exchange is a transaction in which you trade one currency for another. And this brings up the price involved in such a transaction, which is called the foreign exchange rate. The foreign exchange rate is the rate at which one currency is traded for another. What we're going to do now is begin a series of discussions, in which we look at the market in which one currency, say US dollars, is traded for another currency, say Mexican pesos. What's actually being traded? How is the price at which this trade is conducted being determined? And why does it matter? I find that the most difficult things about foreign exchange discussions are just the definitions and the notation. So what I'm going to do first is explain what we're talking about when we used terms like appreciation, depreciation, foreign currency and foreign exchange.
Let's begin by asking what is the foreign exchange market? Well, you did a kind of retail transaction when you went to the airport and traded your green US dollars for these paper Mexican pesos. Most foreign exchange transactions, however, are wholesale transactions. They are done in very, very large quantities. Suppose you are a Mexican businessman who lies in Guadalajara and you are going to be in the business of cellular telephone imports from the United States. You import cellular telephones that are manufactured in California and you sell them to clients in Guadalajara. Suppose then that you need US dollars in order to do this transaction. After all, the company in California is not going to take Mexican pesos, because they have to pay their workers in dollars. Therefore, you need US dollars to do this transaction.
So the first thing you need to do is acquire US dollars. Since you're in Guadalajara and you sell these telephones to Mexicans for pesos, you have pesos and you want to get dollars. This means you're going to do a foreign exchange transaction. Now, since you're in business, you're going to be doing a lot of these transactions, so you're going to get a better price by doing them at a wholesale rate. Most foreign exchange transactions are wholesale transactions done between banks and large financial institutions. So let's do an example then of how that might work.
There's a bank in California that operates in the same market as the company that manufactures the cellular telephones. There's a bank in Guadalajara that operates in the same market as your business, where you cell the telephones. So here's what you're going to do: you need 1 million US dollars in order to purchase a year's shipment worth of cellular telephones, so what you'd like to do is get a bank account in California with 1 million US dollars deposited in it. That way, you could write checks on that account to write to the company that's going to be shipping you the telephones. You have pesos in your bank in Guadalajara, so you call the bank and say, "Exchange my Guadalajara bank account, or take some of the pesos out of it, and buy me a bank account in California, so that I can do the transaction there." What your bank will then do is take the money out of the Guadalajara account, exchange it with a California bank and then send you a notice that you now have $1,000,000.00 on deposit in California. The rate at which this transaction occurs, the rate at which peso are exchanged for dollars in this transaction, is called the foreign exchange rate, or the dollar-peso exchange rate. And let's suppose, for the sake of our example, that 10 million pesos can be exchanged for 1 million US dollars today on the foreign exchange market. Now, there are lots of players in this market and, if you weren't getting the best deal between your Mexican bank and the bank in California, you could go to a bank in Chicago or a bank in London. And, because they're all competing, the foreign exchange rate is pretty much the same, regardless of who you're dealing with, because of the pressures of supply and demand.
Now, if you need the money today and you call the bank and say, "We need it by 5:00 in California," this is what's called a spot transaction. A spot transaction trades dollars for pesos right now. On the other hand, if you know that you're not going to need the US dollars for three months or six months and you want to go ahead and lock in an exchange rate today so that you don't face the risk of fluctuating currency prices, you can do what's called a forward transaction. A forward transaction is a contract that's entered into today, in which two parties agree to exchange currency at a given rate on some given date in the future. A forward contract is typically one that's entered into between two parties for an amount that they choose on a date that they choose in the future. Forward contracts are a way of sharing risk. People who enter forward contracts want to protect themselves against the uncertainty created by fluctuating currency prices.
Now to the tricky matter of notation. e is going to be the symbol we use to foreign exchange rate, but what does that mean? We're going to say that the foreign exchange rate is the number of units of foreign currency you can buy with one unit of domestic currency. So if we're talking about the exchange rate from the perspective of someone in the United States, it's the number of pesos you that can buy with 1 US dollar. So, for instance, if you can buy 10 pesos with $1.00, as in the example we just gave, then the exchange rate is 10, 10 pesos to the dollar. Now, the foreign exchange rate from the point of view of Mexico would be just exactly the opposite. It would be the number of dollars you could buy with 1 peso. So, take the reciprocal of that number and you get 1 over 10; that is, one-tenth of a US dollar or one dime per peso. In general, it's always true that the exchange rate from the point of view of Mexico is going to be the reciprocal of the exchange rate from the point of view of the United States; that is, the dollar per peso ratio is always the reciprocal of the peso per dollar ratio. That's why, when you look at the Wall Street Journal or the New York Times report on foreign currency prices, the foreign exchange table that appears on the newspaper every business day, you'll see in one column that it's reported as dollars per peso and in another column it's reported as pesos to the dollar. And you can look at the numbers very quickly and see that they are reciprocals of one another.
So there you have it. That's the way the foreign exchange rate is written and that's what it refers to. Now, the last question for this discussion is: why should you care? And let's look at an example that makes very clear that the exchange rate determines the cost of doing business across international boundaries. And let's go back now to the perspective of that businessman in Guadalajara, who is important cellular telephones from California.
Let's suppose that the price in US dollars of one cellular telephone is 100. 100 US dollars is the price at which you can buy a cellular telephone in California. Let's suppose at time zero, the beginning of our example that 10 pesos trade for 1 US dollar. That's the exchange rate. Now, if that's the case, then, in Guadalajara, the price of the camera in US dollars times the number of pesos that it takes to get one 1 US dollar determines the cost to that businessman of importing the telephone in pesos, his local currency. So $100.00 times 10 pesos to the dollar means that the Guadalajara businessman has to pay 1,000 pesos to get the cellular telephone.
Now, suppose instead that the exchange rate changes at e[1] to be 12 pesos to the dollar. Before we look at the implications, let's get clear on a matter of definition. If the exchange rate goes from 10 pesos to the dollar to 12 pesos to the dollar, we say that the Mexican peso has depreciated with respect to the US dollar. That means that it takes now more pesos than before to buy $1.00. That is, the peso has lost value. If that's the case then, what happens is you end up paying more pesos than before to import something from the United States and, in fact, to get $100.00 to buy the cellular telephone, the businessman now has to spend 12 pesos to the dollar times $100.00, or 1,200 pesos. Whenever your currency depreciates, you have to pay more to import goods from abroad. However, let's suppose that at e[2] the exchange rate is 8 pesos to the dollar. Now we say that the peso has appreciated. It takes fewer pesos to get 1 US dollar, or 1 US dollar buys fewer pesos. So if the peso appreciates, then we wind up spending 8 pesos to the dollar time $100.00. At time 2, it takes only 800 pesos to import the same cellular telephone. If your country's currency appreciates, then you spend less of your local currency to import goods from abroad.
So, from the perspective of the Mexican importer, when the Mexico peso appreciates, then he is in a good situation, because he spends less of his local currency to import a good from abroad. On the other hand, if the peso depreciates with respect to the dollar, he's in a bad position, because he has to spend more of his local currency, in order to import the cellular telephone from the United States.
Now, who then, in general, likes for their country's currency to become stronger? If you are importing goods from abroad, you like for your local currency to be strong. That means you can spend less of it on foreign goods and get more. On the other hand, if you are a businessman in Mexico who produces cellular telephones in Mexico City, you like for the peso to depreciate, because that means it's more costly for your friend in Guadalajara to import phones from California. He's got to raise the price in the local market to 1,200 pesos to cover the cost. That allows you in Mexico City to charge a higher price for the competing cellular telephones that you are making, and that's good for your business. So an industry that is competing with imports in Mexico likes for the Mexican peso to depreciate. That makes it harder to import competition into the country. Meanwhile, the people who live in the United States who are sending cellular telephones to Mexico, they like for the Mexico peso to appreciate. That's because their clients in Mexico are then enable to import these hundred dollar cellular telephones with less pain. The California imports become more competitive in Mexico when the Mexican peso appreciates.
So there you have it. The foreign exchange rate determines the price of doing business across international boundaries. Whenever you live in Mexico and the peso depreciates, it's more expensive to import goods from abroad, and therefore local producers have a competitive edge. On the other hand, when the peso appreciates, it's easy to import goods from abroad and local competitors face stiffer competition from people importing stuff from the United States.
Now, we're going to consider what causes the foreign exchange rate to appreciate or depreciate; that is, what sets the price at which dollars can be exchanged for pesos. And, as usual with any price, it boils down to supply and demand. So we'll consider where the supply and demand for foreign exchange come from. But first, we're going to look at the relationship between exchange rates and prices across international boundaries to see how the cost of living influences the foreign exchange rate in the very long run.
International Focus
Exchange Rates
Nominal Exchange Rates Page [3 of 3]

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