Purchasing Foreign Currency

Most countries exchange many goods and services with other countries. Usually, before a product can be purchased from a foreign country, the buyer needs to buy the foreign country’s currency. For example, a United States business purchasing German cars must first buy Euros before it can pay the German exporter for the cars.

The values of most currencies fluctuate on a daily basis. For example, 100 Moroccan Dirham may exchange for $10 (US) today, while next month it could exchange for $11. For a quick way to find currency exchange values, type “currency converter” in the Google (or any other search engine) search field.

In addition to currencies supplied by central governments, there are also virtual currencies accumulated in online games. People who play games online (for example, Second Life) may accumulate game money and exchange this (buy or sell) for conventional currencies.

Bitcoins

A new form of currency (not based on games), called Bitcoins, is gaining popularity and acceptance. An unknown Japanese business person created this virtual currency whose supply is entirely non-physical and based on a complicated mathematical formula. BitcoinBitcoins are used for a variety of online transactions and, while gaining acceptance in conventional trade, are especially popular in the underground economy. The value of one bitcoin has ranged from approximately $120 (US) to more than $1,000. As with many other currencies, the value of the bitcoin is determined by traditional supply and demand forces. The greater uncertainty (relative to established physical currencies) of the Bitcoin’s value makes it a risky currency to use. An advantage of paying for or accepting Bitcoins is that it is quick and cheap to transfer and therefore especially popular in international transactions.

How Do Fluctuations in Exchange Rates Affect Imports and Exports?

Fluctuating exchange rates affect what an importing business pays for the foreign product. For instance, if the value of the Nigerian Naira relative to the U.S. dollar falls, then Nigerian products purchased by American businesses become less expensive. The following example illustrates this.

Let’s say that this month an American oil importing company purchases 100 barrels of Nigerian oil. The following amounts are given (hypothetical data):
Nigeria sells its oil for 10,000 Nigerian Naira per barrel.
$1 exchanges for 131 Nigerian Naira.
Therefore, one barrel sells for 10,000 divided by 131, or $76.34.
Therefore, 100 barrels of Nigerian oil costs the U.S. company 100 times $76.34, or $7,634.

If next month the U.S. exchange rate becomes 135 Naira per dollar, the following happens:
Assume that Nigeria still sells its oil for 10,000 Nigerian Naira per barrel.
$1 now exchanges for 135 Nigerian Naira.
Therefore, one barrel sells for 10,000 divided by 135, or $74.07.
Therefore, 100 barrels of Nigerian oil costs the U.S. company $7,407.
Compared to the month before, the U.S. importing company is paying less for the 100 barrels of oil.

The above shows that if the U.S. dollar increases in value (we receive more of their currency per dollar), then the price we pay for the foreign product decreases. If the U.S. dollar decreases in value, then the price we pay for foreign products increases.

The following is an example of a foreign country purchasing a product from the U.S.

Let’s say that this month a Japanese software-importing company purchases 500 software licenses from an American company. The following amounts are given:
The U.S. company sells its software for $40 per software license.
$1 exchanges for 120 Japanese yen.
Therefore, one software license costs the Japanese importer $40 times 120 Japanese yen, or 4,800 yen.
Therefore, 500 software licenses cost the Japanese company 500 times 4,800 yen, or 2.4 million yen.

If next month the U.S. exchange rate becomes 125 yen per dollar, the following happens:
The U.S. company still sells its software for $40 per software license.
$1 exchanges for 125 Japanese yen.
Therefore, one software license costs the Japanese importer $40 times 125 Japanese yen, or 5,000 yen.
Therefore, 500 software licenses cost the Japanese company 500 times 5,000 yen, or 2.5 million yen.
Compared to the month before, the Japanese company is paying more for the imported products.

The above shows that if the U.S. dollar increases in value (we receive more of their currency per dollar; they receive fewer of our currency per yen), then the price that foreign countries pay for a U.S. product increases. If the U.S. dollar decreases in value, then the price a foreign country pays for U.S. products decreases.

China’s exchange rate policies have come into the news lately because its government has been accused of manipulating its value. The Chinese government has kept its currency, the Yuan Renminbi, artificially low in order to make its exports less expensive. As the above example illustrates, if a country’s currency decreases in value, its products become less expensive to foreign countries. The United States and other countries have complained to the Chinese government and asked it to allow the Yuan Renminbi to fluctuate according to free market forces.

Exchange Rate Determinants

Exchange rates in free (flexible) markets fluctuate with changes in supply and demand for the currency. The main determinants of demand for and supply of a currency are a country’s economic and political stability, its inflation rate, its real return on investments, and speculators’ expectations of the future value of the currencies. For example, if a country experiences a low rate of inflation and economic stability, then foreign countries will be more likely to invest in that country and purchase their products. This increases the demand for the country’s currency and raises the value of its currency. A higher real return on investments also increases demand for a currency, as investors will purchase more of the country’s stocks and bonds (or other investments) due to the higher rate of return.

An Increase in the Demand for a Currency

An increase in the demand for a currency will increase its value, and vice versa. The graph below illustrates an increase in the demand for dollars relative to the Euro. This leads to an increase in the value of the dollar relative to the Euro. The equilibrium value of the dollar increases from .80 Euros per dollar to .90 Euros per dollar.

An Increase in the Supply of a Currency

An increase in supply of the currency will decrease the value of the currency, and vice versa. The graph below illustrates an increase in the supply of dollars relative to the Euro. This lowers the value of the dollar relative to the Euro. The equilibrium value of the dollar decreases from .90 Euros per dollar to .80 Euros per dollar.

Video Explanation
For a video explanation of foreign exchange rates and how changes in the rates affect prices of imports and exports, please visit: