Page 162 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance Pavitar Parkash Singh, Lovely Professional University

Notes
Unit 14 : Exchange Rate : Meaning and Components

CONTENTS
Objectives
Introduction
14.1 Meaning of Exchange Rate
14.2 Components of Exchange Rate
14.3 Summary
14.4 Key-Words
14.5 Review Questions
14.6 Further Readings

Objectives

After reading this Unit students will be able to:
• Know the Meaning of Exchange Rate.
• Discuss the Components of Exchange Rate.
Introduction

In virtually all modern economies, money (i.e. currency) is created and controlled by a central
governing authority. In most cases, currencies are developed by individual countries, though this
need not be the case. (One notable exception is the Euro, which is the official currency for most of
Europe.) Because countries buy goods and services from other countries (and sell goods and service
to other countries), it’s important to think about how currencies of one country can be exchanged for
currencies of other countries.
Like other markets, foreign-exchange markets are governed by the forces of supply and demand. In
such markets, the “price” of a unit of currency is the amount of another currency that is needed to
purchase it. For example, the price of one Euro is, as of the time of writing, about 1.25 US dollars,
since currency markets will exchange one Euro for 1.25 US dollars.
These currency prices are referred to as exchange rates. More specifically, these prices are nominal
exchange rates (not to be confused with real exchange rates). Just as the price of a good or service can
be given in dollars, in Euro, or in any other currency, an exchange rate for a currency can be stated
relative to any other currency. You can see a variety of such exchange rates by going to various
finance web sites.
A US Dollar/Euro (USD/EUR) exchange rate, for example, gives the number of US dollars than can
be bought with one Euro, or the number of US dollars per Euro. In this way, exchange rates have a
numerator and a denominator, and the exchange rate represents how much numerator currency can
be exchanged for one unit of denominator currency.
Because currency prices are stated relative to another currency, economists say that currencies
appreciate and depreciate specifically relative to other currencies.
Appreciation and depreciation can be inferred directly from exchange rates. For example, If the USD/
EUR exchange rate were to go from 1.25 to 1.5, the Euro would buy more US dollars than it did
before. Therefore, the Euro would appreciate relative to the US dollar. In general, if an exchange rate
increases, the currency in the denominator (bottom) of the exchange rate appreciates relative to the
currency in the numerator (top).

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