Exchange Rates and Trade

If an American wants to buy a vacuum cleaner in China, they will need to exchange their

American dollars for Chinese yuan. Most countries have different currencies,

and these currencies are competing with one another. For example, the difference between

a Canadian dollar and a Japanese yen does not stay the same from day to day. These fluctuations can

have a big impact on imports and exports and can make international trade even more complicated.

In this tutorial, we will look at the effects of changes in exchange rates on world trade.

First of all, the value of a country’s currency in relation to a foreign currency is called the

exchange rate. If you understand exchange rates, you can convert prices in one currency to prices

in another currency. Exchange rates change daily, but these days they are easy to keep track of.

A currency’s value goes up or down in relation to other currencies. An increase in the value of

currency is called appreciation, and a decrease in its value is called depreciation. If the

exchange rate between the Canadian dollar and the Japanese yen increases from 100 yen per dollar to

120 yen per dollar, each dollar can buy more yen. Because the dollar has increased in value, it has

appreciated against the yen. This appreciation means that people in Japan will have to spend more

yen to purchase a dollar’s worth of goods from Canada. When a country’s currency depreciates,

its goods become cheaper to other countries, which usually means they export more stuff.

Now, suppose a company in Canada sells oil in Japan. That company is paid in yen. But back

in Canada, it has to pay its workers and suppliers in dollars. Therefore, the company has to exchange

its yen for Canadian dollars. This exchange takes place on the foreign exchange market,

which is made up of around 2,000 banks and other financial institutions that facilitate

the buying and selling of foreign currencies. There are two main ways governments adjust the

value of their country’s currency. A system in which governments try to keep the values

of their currencies constant with respect to one another is called a fixed exchange-rate system. In

a fixed exchange-rate system, countries typically fix, or peg, their exchange rates to one country

with a strong, stable currency. At the end of World War Two, representatives of 44 countries

met in the United States, specifically Bretton Woods, New Hampshire. Their goal was economic

stability for the postwar world. At what became known as the Bretton Woods Conference,

the representatives agreed to peg their currencies to the United States dollar since they thought the

United States had the strongest economy in the world, and therefore the most stable currency. To

carry this out, conference participants created the International Monetary Fund, or IMF. Today,

the IMF still promotes currency stabilization and monetary cooperation. The second way governments

adjust the values of their countries’ currencies to other countries’ currencies is a flexible

exchange system. In this system, the exchange rate is determined by supply and demand, rather than

according to any preset range. When the current flexible exchange-rate system was first adopted,

some economists worried that changes in the exchange rate might interfere with the flow

of world trade. However, trade has actually grown quickly since the flexible exchange-rate system

was adopted. Today, most countries use a mixture of fixed and flexible exchange rates to account

for the day-to-day changes in currency values. Because the value of a country’s currency is

affected by the overall flow of goods and services into and out of a country, exchange rates often