Currencies and Exchange Rates
Currencies and Exchange Rates

To understand why countries export,  lets us start by looking at the idea of exchange rates. Have you ever thought of the idea how there is no universal currency? Instead, different countries have different currencies (also called ‘monetary units’) and each currency has its own value. This value is not set, but fluctuates based on a variety of factors.

The exchange rate is determined by the ratio of sum A—an amount of domestic currency compared to a sum of B—an equivalent amount of foreign currency.  For example, the ratio of the domestic prices for a basket of goods and the foreign prices for the same basket of goods is a good approximation for the exchange rate of the domestic currency and foreign currency.

Another example: in 2009 one U.S. dollar had the buying power of roughly 31.5 rubles in Russia. Imagine that in the United States, a can of soda fromin a vending machine costs one U.S. dollar. In Russia, if you are thirsty and want to purchase a can of soda from a vending machine, how much should you have? Since we are comparing the same thing from the basket of goods both countries have, you should have the equivalent of one U.S. dollar in Russia’s currency, or 31.5 rubles.

Currency converters that are available online at http://finance.yahoo.com/m3, or http://www.xe.com/ucc/  will calculate how much a given amount of one currency is worth in another currency.

Thus a single ruble is worth about $.03 U.S.—that is about 3 cents. The exchange rate of dollars to rubles is therefore .03.

Sometimes, however, the exchange rate doesn’t tell the whole story. For instance, a U.S. dollar in 2009 is worth about the same as 34 Thai baht. Still, a Big Mac, which costs about $3.57 in the United States, can be purchased for as little as 60 to 80 baht in Thailand, which is the equivalent of $1.75 to $2.34 (Orient Expat, 2012).

This difference in price is due to the fact that exchange rates reflect both the local market conditions and the calculations of currency traders about the overall prospects of an economy. For example, when currency traders predict that a nation is going to undergo a bout of inflation in the near future, making their currency less valuable, they are likely to sell their holdings of that currency, just like any other commodity. (The term commodity usually refers to basic goods that are generally easily substitutable for any other of its kind. Metals, such as gold or aluminum, or basic foods, such as oranges or cattle, are considered commodities.)

Because exchange rates are comprised of these two factors, economists sometimes measure the value of a currency according to the Purchasing Power Parity (PPP) Index. Put most simply, the PPP rate of a currency can be calculated by comparing the cost of a basket of goods in one country to the cost of that same basket of goods in another country.

 The Economist magazine each year famously publishes what it calls the “Big Mac Index,” which measures the price of a Big Mac hamburger sold at McDonald’s restaurants around the world, and then compares those prices to the exchange rate of other currencies. Many observers find that their index proves to be a surprisingly accurate predictor of exchange rate changes.  

The exchange rate is a key determinant of  international trade. When a company in one country wants to import goods from a company in another country, it typically must pay for the exporting either in that country’s currency or in the currency of one of the world’s major economies. These currencies– the United States dollar, the European euro, the British pound sterling, the Japanese yen, and the Swiss franc–are collectively known as hard currencies. Most countries do not use a hard currency in their domestic economy; you could not use them to buy a Big Mac in Thailand or a soda in Russia.  In order to participate in the international economy, however, countries must have some stock of a hard currency.

 

Next:  Why do Nations Import?