Currency Exchange Rates

BRIEF REVIEW OF INTERNATIONAL CURRENCY EXCHANGE RATES

Since international trade is conducted using money, the student needs to know the basics of currency exchange rates. The first thing to know is that exchange rates between different currencies are determined by supply and demand. A currency exchange rate is just one currency expressed in terms of another–just as wheat is priced in terms of dollars, for example, so can the market value of one British pound sterling be expressed (priced) in terms of dollars. But equally, so can the price of one dollar be expressed in terms of pound sterling.

For example, if the price of one pound sterling is $2.00, then the price of one dollar is 0.50 pound sterling. We write it this way: £ 1 = $2.00 and $ 1 = £ 0.50

The graph of demand and supply curves representing the market for pound sterling will have the symbol "£" written on the Q (Quantity) axis, because it is the quantity of pounds that we are buying and selling. And the graph will have the symbol "$" written on the P (Price) axis because the pound is being priced in terms of dollars.

The demand curve for pounds will slope downward to the right, as usual for any demand curve, because as the pound becomes cheaper in terms of dollars (there is a lower dollar price for pounds), British goods will seem cheaper to Americans in terms of dollars, and Americans will want to buy more pounds in order to buy the British goods. For example, if the price of pounds should fall from £ 1 = $2.00 to £ 1 = $1.50, then a British good costing £ 1 will seem to Americans to have fallen in price form $2.00 to $1.50, and Americans will buy more of the British good. But they will need British pounds to do so, and so the amount demanded of pounds will increase.

The supply curve for pounds will slope upward to the right, as for any supply curve, because as the pound brings a higher price in terms of dollars, the British will want to sell more pounds, as is true for any good. For example, if the price of £ 1 should rise from $1.50 to $2.00, then the price of a dollar in terms of pounds will fall, from $ 1 = £ 0.67 to $ 1 = £ 0.50. American goods will seem cheaper to the British, who will buy more American goods, but will need more dollars to do so, and therefore they will offer more pounds in order to buy the dollars (with which to buy the goods)–so the amount supplied of pounds will increase as the price of pounds increases (the supply curve of pounds will slope upwards to the right).

The exchange rate between dollars and pounds (the dollar price of pounds) will reach equilibrium where the demand and supply curves cross, as usual.

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This page was last updated on Friday, July 21, 2006.