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Unlock This CourseEvery country has its own money. A shop in Kenya wants shillings. A shop in Japan wants yen. So when people trade across borders, one currency has to be swapped for another.
Key terms:
An exchange rate is just a price. It tells you how much of one currency you must give up to get one unit of another. Here is a made-up example. Suppose the rate is:
$1 = 4 koras (the kora is the made-up currency of the country of Zelvoria)
This means that one US dollar costs 4 koras. It also means that one kora costs $0.25, because $1 ÷ 4 = $0.25. The same rate can be written either way round.
You use the exchange rate to find what something costs in your own currency. The rule is simple:
A quick check helps. Four koras are worth one dollar, so one kora is worth less than a dollar. Your number of koras should therefore be bigger than your number of dollars.
The rate is $1 = 4 koras. A pair of headphones costs $35 in the USA. What is the price in koras?
$35 × 4 = 140 koras.
The rate is $1 = 4 koras. A hotel room in Zelvoria costs 600 koras a night. What is the price in dollars?
600 ÷ 4 = $150.
A made-up rate is $1 = 0.80 euros. A tourist swaps $250 for euros. How many euros does the tourist receive?
250 × 0.80 = 200 euros.
In each case, look at which currency is on the left of the rate and which is on the right. Rule: if you start with the currency that has the 1 in the rate (dollars here), multiply. If you start with the other currency (koras here), divide.
People swap currencies in the foreign exchange market, which you met in the lesson on how markets work. There are six main reasons why they do it. Every one of them means someone needs a currency that is not their own.
Exporters usually want to be paid in their own currency. A Zelvorian importer who buys machines from a firm in the USA must first buy dollars with koras. The same is true for services such as tourism, insurance and shipping.
Speculation is buying something in the hope that its price will rise, so that it can be sold later at a profit. A speculator might buy a currency that they expect to become more valuable, then sell it after the price rises.
Government intervention in currency markets means a government, usually through its central bank, buys or sells currencies to influence the exchange rate. For example, it may buy its own currency to stop its price falling.
Firms and people own businesses and lend money across borders. A foreign-owned factory may send its profit back to its owners. Borrowers pay interest on loans, and companies pay dividends (a share of profit) to shareholders. These payments are made in the owners' or lenders' currency.
Remittances are money sent home by workers who live and work in another country. A nurse working abroad may send part of her pay to her family. The family needs its own currency, so the money is swapped.
Capital goods are goods such as machines and equipment that are used to make other goods. A firm that builds a new factory abroad, or buys machines from another country, needs foreign currency to pay for them.
Key terms:
How the price of a currency is actually decided, and what happens when it changes, come in the next two lessons: How Exchange Rates Are Determined and Effects of Exchange Rate Changes.
Multiplying when you should divide. Check the answer: if $1 buys 4 koras, the amount in koras must be bigger than the amount in dollars.
Writing that exchange rates only matter for tourists. Firms, banks, governments and workers all need foreign currency.
Forgetting that a rate can be written two ways. $1 = 4 koras is the same as 1 kora = $0.25.
Pondara is a small country with the currency the lira. Many Pondarans work in other countries and send money home. A Pondaran bakery has bought two new ovens from a firm in the USA. Today's made-up rate is $1 = 5 liras.
(a) Define foreign exchange rate. [2 marks]
(b) Calculate how many liras are needed to buy an oven that costs $2,000. [2 marks]
(c) Explain two reasons why currencies are bought and sold. [4 marks]
(a) A foreign exchange rate is the price (1) of one currency in terms of another currency (1).
(b) $2,000 × 5 (1) = 10,000 liras (1).
(c) The bakery buys ovens from the USA, so it needs dollars to pay the American firm (1), because the firm wants to be paid in its own currency (1). Another reason is workers' remittances: Pondarans living abroad send money home, so their families swap the foreign currency for liras (1), which they need to spend in Pondara (1).
In a calculation, show the sum and the answer. If the rate is $1 = 5 liras, going from dollars to liras means multiplying by 5.