First of all, what is currency? Well, currency is a unit of national exchange.
EXAMPLEThe currency in the United States is the dollar, and in Canada, it is the Canadian dollar. Many countries in Europe currently use the euro, while in Great Britain, the currency is the pound.
The exchange rate is the value of one currency relative to another. Exchange rates are subject to demand factors, and as a currency is more highly sought after than another, its value will tend to appreciate or increase relative to the other. Conversely, if it falls in comparison to the other, its value depreciates.
On a country level, exchange rates matter because they impact how much Americans want to purchase foreign goods or imports. They also impact how much foreigners want to purchase our goods, so it affects our exports as well.
$1 U.S. Dollar = €.75 Euro
Now, suppose you want to purchase a German car that costs €40,000.
First, you would need to exchange or supply your U.S. dollars for euros. In this case, you would actually be demanding euros.
How many U.S. dollars would you need? If you perform the calculation, you would need about $53,333 in U.S. dollars, since $1 can only purchase 3/4 of the other currency, which in this case is the euro.
€40,000 / .75 = $53,333
As you can see, how exchange rates are expressed depends on the source, or which country is quoting the exchange rate.
EXAMPLEFor example, it could be quoted as the U.S. dollar to the euro is .75, or the euro to the U.S. dollar is .75, depending on the source, which can be quite confusing. What does matter is which one is the base currency and which is the price currency, which we will cover in the next section.
Let's go back to the example where one U.S. dollar can purchase .75 euros. Now, another way of thinking about this is that one U.S. dollar (USD) can be purchased for a price of .75 euros (EUR).
Put this way, you can see that the U.S. dollar becomes the base currency, because one unit of that currency, one dollar, is being purchased.
The euro, on the other hand, is the price currency, because it is the price of one unit of that base, or the one U.S. dollar, in this case. Therefore, the price to purchase one dollar is .75 of a euro.
Base currency defined, then, is the currency being purchased in an exchange rate calculation. The exchange rate 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.
EXAMPLELet's reverse our example from above. We could say that one euro can purchase 1.33 U.S. dollars, meaning it would take 1.33 U.S. dollars to purchase one euro. Now the euro becomes the base currency because we are looking at one unit of that currency. In order to purchase that one unit in euros, the price is 1.33 U.S. dollars, so the U.S. dollar is the price currency.
So, are exchange rates stable or volatile? Well, they could be both, because they are constantly changing.
Exchange rates change as a result of economic conditions in one country compared to another. Now, even though they are changing slightly day to day, there is usually not a dramatic change. When there are significant changes, it is the result of changing economic conditions.
EXAMPLEIf the United States buys a lot of goods, or imports, from another country, then they are supplying a lot of dollars and demanding much of the other currency. Therefore, the dollar would tend to depreciate against the other currency.
Remember, when the supply of something increases--in this case, dollars--its value tends to go down. At the same time, demanding a lot of the other currency would drive its price or value up.
Overall, the exact values of exchange rates are not overly predictable. However, there are definitely some existing models that can predict whether an exchange rate will go up or go down, so its overall direction can be predicted.
Source: Adapted from Sophia instructor Kate Eskra.