ECO/372 - Principles of Macroeconomics
May 13, 2013
Foreign Exchange Rates
One may try to understand what exactly a foreign exchange rate is. To help understand, let’s view a foreign exchange rate as exchanging one dollar at a department store for a product. If one were to go into a department store and purchase a pair of socks in a three pack for one dollar, or each for 33 cents, one would be able to relate that the dollar-to-socks exchange rate is three socks because one exchanged a single dollar for three pairs of socks. Similarly, the sock-to-dollar exchange rate would be one-third of a dollar, meaning 33 cents. This is because if one decides to sell a single pair of socks, one would get 33 cents in exchange. (Moffatt) The same principle hold true for foreign currency. On May 9, 2013 the U.S.-to-Euro exchange rate was .767 EUR, meaning that for one U.S. dollar, one could purchase .767 Euros. In order to determine the amount that one could exchange one Euro to the dollar, one could use this simple formula: Euro-to-U.S. exchange rate = 1 / U.S.-to-Euro exchange rate. Euro-to-U.S. exchange rate = 1 / 3767 = 1.303.
This equation shows that one Euro would be exchange for 1.303 U.S. dollars. (Moffatt) Now that what have an understanding of what a foreign exchange rate is, let discuss how these rates are determined. Using the two previously discussed currencies, each of their rate are determined in a foreign exchange market that is open to a very large range of various sellers and buyers. Each country incorporates mechanisms that will in turn aid in managing the value of their currency. These mechanisms help in determining the, either pegged and fixed, or free-floating. A peg system is when a country tries to keep their currency at a fixed exchange rate, as the Chinese have done between 1994 and 2005....