FOREIGN EXCHANGE RATES

Many people's contact with the world of foreign exchange is limited to changing money for use when traveling in, or buying things from, other countries. Suppose a U.S. tourist traveling in France wants to buy a sweater. The price tag says 500 francs. Before going shopping, the tourist visits a bank and converts, or exchanges, U.S. dollars for French francs. At the bank, he is told the exchange rate at the time is 5.5 francs to $1. The tourist determines that the 500 franc cost of the sweater is the equivalent of paying $90.91.

However, exchange rates can change at any time, so whenever we engage in FX transactions, we take a risk. There's always a chance that our purchases could actually be less expensive—or, unhappily, more expensive—if we wait to buy them. For example, if the exchange rate changes from 5.5 to 5.6 on the next day

(a huge change by market standards) the 500 franc sweater will cost the tourist only $89.29 instead of $90.91. The franc is said to have "fallen" or lost value against the dollar, because $ 1 will buy more francs than before. The dollar is said to have "risen" against the franc. However, if the rate is 5.4, the franc is said to be stronger, or to have "risen" against the dollar, while the dollar has "weakened" against the franc. At 5.4, $1 will buy fewer francs, and our tourist's sweater will cost $92.60. These price changes may not seem very significant, but when billions of dollars are involved, even a hundredth of a percentage point change in the exchange rate becomes important.

What effects do exchange rate fluctuations have on a country and the world economy? If one currency can buy an increasing amount of another currency it is said to be "strong." However, just because a currency is strong does not mean that everyone in that country is better off. A stronger dollar means that Americans can buy foreign goods more cheaply, but foreigners will find U.S. goods more expensive. If you work in a company that relies on the sale of exports, a stronger dollar probably is not going to help your firm's business. The goods you produce will be more expensive to foreigners, who therefore may not buy as many. If you are an importer, by contrast, your cost of purchasing foreign goods will drop.

Therefore, it would be logical to assume that if the dollar were weaker, the U.S. trade balance would improve, as foreigners bought more American goods. However, after the dollar depreciates, the U.S. trade balance usually worsens for a few months. A phenomenon called the J-curve explains why: most import/export orders are taken months in advance. Just after a currency's value drops, the volume of imports remains about the same, but the price of the ordered imports rises in terms of the home nation's currency. In the meantime, the value of domestically produced exports tends to remain constant. The difference in value worsens the country's trade balance, until the volumes of imports and exports fully adjust to the new exchange rate.

Exchange rates also are a very important factor to consider when making international investment decisions. Just as our tourist's sweater may increase or decrease in price based on changes in exchange rates, money invested overseas incurs the same risk. When the investor decides to "cash out," or bring his money back home, any gains could be magnified or wiped out, depending on the changes in exchange rates. Companies that do a great deal of international business must watch exchange rates carefully to try to protect and increase their profits.

In short, changes in foreign exchange rates affect prices of import-

ed goods and the overall level of price and wage inflation in an economy. Tourism patterns may change depending on where currencies can buy the most. Confidence in a currency's strength also may encourage consumers to buy and investors to make long-term commitments.

Date: 2015-12-24; view: 843