Definition

The exchange rate of a currency is the price of this currency in relation to another currency.

Rising interest rates can also reduce exports and increase imports via the exchange rate.

Note: The lower interest rates are, the more consumers borrow. A lower interest rate makes loans cheaper and increases demand.

Computing the exchange rate

Most exchange rates are floating and go up or down depending on supply and demand in the market.

Example 1:

If $€ 1=€ 0.85$, then: $€ 1=€ 1.18$, indeed: $€ 1=\dfrac{1}{0.85}=€ 1.18$

Example 2:

If $€ 1=£ 0.85$ and $€ 1=\$ 1.26$, then $€ 1=\$ 1.07$, indeed:
$€ 1=0.85 \times 1.26=\$ 1.071 \approx \$ 1.07$

Example 3:

On date t1, the exchange rate between UK pounds and Euros was $£1 = €1.20$. On date $t_2$, the exchange rate was $£1 = €1.50$.

On date $t_1$ a student had $£100$ when he left England to France. How much did he have when he got back to England, knowing that he hadn’t spent the money?

Let’s first convert UK Pounds into Euros at date $t_1$:

$€ 100=100 \times 1.20=€ 120$

Next, let's convert Euros into UK Pounds at date $t_2$:

$€ 120=\dfrac{120}{1.5}=€ 80$

When he returned, he finally had $£ 80$.

Purchasing Power Parity (PPP)

  • The PPP establishes a comparison, between countries, of the purchasing power of national currencies, which the mere use of exchange rates does not make it possible to do.
  • Computing PPP:
    $\underline{\text{PPP}} =\dfrac{\text { cost of good A in currency } 1}{\text { cost of good A in currency } 2}$
  • $\rm PPP$ stipulates that the price levels between two countries must be equal.
    This means that the goods in each country will cost the same once the currencies have been exchanged.