Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on foreign exchange and currency. As always, my key terms are in red and my examples are in green.
In this tutorial, we'll talk about how to interpret an exchange rate depending on how it's expressed. And you'll understand the difference between the base currency and the price currency when we're calculating exchange rates.
So first of all, what is currency? Well, currency is just a unit of national exchange. So our currency in the United States is the dollar.
In Canada, it's the Canadian dollar. In many countries in Europe now they've gone to the euro. In Great Britain, it's the pound. So that's currency.
The exchange rate is the value of one currency relative to another. And our exchange rates are really subject to demand factors. And as a currency is the more highly sought after than another, its value will tend to appreciate or increase relative to the other. If it falls in comparison to the other, then we would say it depreciates. I'll give you an example of that.
So why do exchange rates matter? Well, on a personal level, I remember when I was traveling in Europe. I went to Spain and Portugal a few years ago. Our exchange rate was actually pretty bad. It was pretty weak against the euro then.
And I remember if we were out and wanted to go to lunch, and a lunch special, let's say, would be 10 euros, I had to say in my mind, wait, that that's not $10. That's actually over 15 US dollars for this. So on a personal level, that's why it matters.
But on a country level, an exchange rate impacts how much Americans want to purchase foreign goods. So it impacts how much we want to import. But it also impacts how much foreigners want to purchase our goods, so it affects our imports as well.
So here's an example for you. Let's just say that one US dollar can purchase 0.75 euros. Back when I was traveling in Europe, it was much worse than that. It was around 0.65 or even a little bit lower than that.
But if it's one US dollar to 0.75 euros, that means that if I want to purchase a car that costs 40,000 euros, what I have to do first-- I can't buy it in US dollars. I have to buy it in euros. So I'd have to exchange or supply my US dollars. And I'd be actually demanding euros in this case.
How many US dollars would I need? If you did the calculation, I would need about 53,333 US dollars, since $1 can only purchase 3/4 of the other currency, the euro in this situation.
So really, it depends on the source. It depends on which country is quoting this. You'll see it sometimes either way. So it could be quoted as the US dollar to the euro is 0.75, or the euro to the US dollar is 0.75, because that's sometimes confusing.
What does matter is which one is the base currency and which one is the price currency. So that's what I'll go through right now. So if we go back to the example where 1 US dollar can purchase 0.75 euros, another way of thinking about this is that 1 US dollar can be purchased for a price of 0.75 euros.
If we think about it that way, you're going to see that the US dollar becomes the base currency, because it's for one unit of that dollar. The euro is the price currency, because it is the price of one unit of that base, or the US dollar in this case. So the price is 0.75 of a euro. That's why the euro is the price currency. The one unit is the US dollar is the base currency here.
So then defined, base currency is the currency being purchased. The exchange rate then provides the amount of the price currency that would be needed to purchase one unit of the base currency, whereas the price currency is the currency exchanged for a unit of the base currency. The exchange rate provides the amount of the price currency needed in the exchange.
So let's look at it, let's reverse things. Let's just say this would be the exact same thing. But now we could say that 1 euro can actually purchase 1.33 US dollars.
So it would take 1.33 US dollars to purchase 1 euro, so now the euro becomes the base currency, because we're looking at one unit of that. And to purchase one unit of that, we need 1.33 US dollars. That's the price. So that becomes the price currency.
So are exchange rates stable or volatile? Well, they could be both. They are changing constantly. There are websites out there that track them minute to minute. You can see the updated exchange rates all the time.
And they change as a result of economic conditions in one country compared to another. So even though they're changing slightly day to day, usually there's not a huge change. When there are huge changes, it's because of a result of changing economic conditions.
One example here is that if the United States tends to buy a lot of goods, so therefore is importing from another country, then what we're doing with that country is like in my car example. We have to supply a lot of our US dollars and demand much of the other currency. Any time you're doing that, think about it.
When the supply of something increases a lot of, its value tends to go down. At the same time, when you're demanding a lot of the other currency, its price or value tends to go up. So what would happen here, the net result would be that the dollar would tend to depreciate against the other currency because of this.
So overall, in terms of the exact values of exchange rates, they're really not predictable. But there are definitely some models out there that will be able to predict whether an exchange rate will go up or go down, so the overall direction of it can be predicted.
In this tutorial, what we talked about is how to interpret an exchange rate depending on how it's expressed. And you looked at the difference between the base currency and the price currency when calculating exchange rates. Thanks
So much for listening. Have a great day.
Terms to Know
The value of one currency relative to another, exchange rate is subject to demand factors, and as a currency is more highly sought after than another, its value will appreciate or increase relative to the other.
A unit of national exchange.
In an exchange rate calculation, the base currency is the currency being purchased. The exchange rate provides the amount of the price currency needed in the exchange.
In an exchange rate calculation, the price currency is the currency exchanged for a unit of the base currency. The exchange rate provides the amount of the price currency needed in the exchange.