Suppose that on January 1 the exchange rate between the US d

Suppose that on January 1 the exchange rate between the U.S. dollar and the European Union euro was $1.40 to buy one euro. On December 31 of that year, a person needed $1.45 to buy one euro. Over the course of that year, did the dollar appreciate or depreciate against the euro? For each of the following cases, identify whether the person is better or worse off and explain why.

a. An American college student spending a year abroad in Europe.

b. An American firm buying a German company.

c. A currency speculator who previously bought Euro with the

expectation that it would appreciate.

d. An American firm that holds French bonds

e. A German bank with 20% of its reserves in US dollars.

Solution

The exchange rate is the price of foreign currency in terms of home currency. The international trade between two countries allows exchange of goods and services. This exchange between two countries involves the exchange of paper money or currency. To conduct the trade one trading partner need the currency of other. The exchange rate determines how much home currency will need to purchase a basket of good that is priced as one unit of foreign currency.

The currencies are bought and sold in the foreign exchange market. The equilibrium price of foreign currency is determined through the demand and supply of home currency in the exchange market. If the price of the foreign currency relative to home currency rises, that is now it needed more of the home currency to purchase one unit of foreign currency, the home currency depreciates. On the other hand, if the price of the foreign currency relative to home currency falls, that is now it needed less of the home currency to purchase one unit of foreign currency, the home currency appreciates.

Therefore, at the end of the year if a person has to pay $1.45 to purchase one euro relative to $1.40 at the begining of the year, implies that dollar has depriciated. This also implies that all the dollar denominated assets have also declined in value.

In this view: