AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/6/6-2)
Unit 6 · Topic 6.2
6.2 Exchange Rates
An exchange rate is the price of one country's currency in terms of another country's currency. If one unit of your currency buys more foreign currency than before, your currency has appreciated; if it buys less, it has depreciated. Exchange rates turn foreign prices into the prices you actually pay.
Key terms
- exchange rate
- currency appreciation
- currency depreciation
- flexible (floating) exchange rate
Reading an exchange rate
An exchange rate tells you how much of one currency trades for one unit of another. '$1.25 per euro' means one euro costs $1.25. It's a price, just like $3 per gallon of gas: the currency after 'per' is the one being bought.
Every rate has a flip side. If one euro costs $1.25, then one dollar costs 1 ÷ 1.25 = 0.80 euros. Both numbers describe the same exchange rate. A news site might list either one, so always check which currency is being priced before you decide what a change means.
Appreciation and depreciation
A currency appreciates when one unit of it buys more of another currency than before: it has become more valuable. A currency depreciates when one unit of it buys less of another currency than before: it has become less valuable.
The two always come in pairs. If the euro rises from $1.25 to $1.50, the euro has appreciated against the dollar, and the dollar has depreciated against the euro: a dollar now buys only 1 ÷ 1.50 ≈ 0.67 euros instead of 0.80.
Watch the units. If a rate is quoted in yen per dollar and the number rises, the dollar appreciated. If it's quoted in dollars per yen and the number rises, the yen appreciated.
Converting prices
To find what a foreign good costs in your money, multiply its foreign price by the exchange rate, written so the units cancel.
When the euro appreciates, European goods get more expensive for Americans, and American goods get cheaper for Europeans. That's how exchange rates change net exports (6.5).
- A €40 shirt at $1.25 per euro costs 40 × $1.25 = $50.
- If the euro appreciates to $1.50 per euro, the same shirt costs 40 × $1.50 = $60.
- A $50 pair of U.S. jeans at 0.80 euros per dollar costs 50 × €0.80 = €40. At 0.67 euros per dollar, it costs about €33.
Flexible exchange rates
In this course, exchange rates are flexible (also called floating). Supply and demand in the foreign exchange market set them, and they change whenever that supply or demand changes (6.3 and 6.4). You won't be tested on fixed exchange rate systems, where a government holds its currency at a set value. Flexible rates move all the time, often a little every day, as people and firms buy and sell currencies to trade and invest.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Flipping a rate
The exchange rate is 150 Japanese yen per U.S. dollar. What's the price of one yen in dollars?
Show the solutionHide the solution
- Step 1: One dollar buys 150 yen, so one yen costs 1 ÷ 150 of a dollar.
- Step 2: 1 ÷ 150 ≈ 0.0067.
Answer: About $0.0067 per yen, or about two-thirds of a cent.
- Example 2Calculator allowed
Which currency appreciated?
The exchange rate changes from 0.90 euros per dollar to 0.75 euros per dollar. (a) Which currency appreciated? (b) How does the euro price of a $20,000 U.S.-made car change?
Show the solutionHide the solution
- Step 1: (a) Each dollar now buys fewer euros (0.75 instead of 0.90), so the dollar depreciated and the euro appreciated.
- Step 2: (b) Before: $20,000 × 0.90 euros per dollar = €18,000.
- Step 3: After: $20,000 × 0.75 euros per dollar = €15,000.
- Step 4: The car got cheaper for European buyers, which tends to raise U.S. exports.
Answer: (a) The euro appreciated and the dollar depreciated. (b) The car's price falls from €18,000 to €15,000.
- Example 3
A number went up: who gained? (classic trap)
A news report says the exchange rate between the Mexican peso and the U.S. dollar rose from 17 to 19. Without units, a student says the peso appreciated. What do you need to know, and what's the answer if the rate is in pesos per dollar?
Show the solutionHide the solution
- Step 1: You need the units, because the same change means opposite things depending on which currency is being priced.
- Step 2: In pesos per dollar, the dollar is being priced. A rise from 17 to 19 means one dollar now buys more pesos.
- Step 3: So the dollar appreciated and the peso depreciated: the opposite of what the student said.
Answer: You need the units. In pesos per dollar, the dollar appreciated and the peso depreciated.
Common mistakes
- Reading a rate backward. In '$1.25 per euro,' the euro is the currency being priced, so a higher number means the euro appreciated.
- Saying both currencies appreciated. If one currency appreciates against another, the other depreciates.
- Converting a price without checking units. Write the units and make sure they cancel, flipping the rate first if needed.
On the exam
- Multiple-choice questions often give a rate and ask you to convert a price, or give two rates and ask which currency appreciated.
- In free-response answers, use the words 'appreciates' and 'depreciates,' and always say which currency.
Connected topics
Videos
Check yourself
4 questions on 6.2 Exchange Rates. Pick an answer to see if you got it, and why.
The exchange rate is $1.25 per euro. What is the price of one dollar in euros?
The exchange rate between the U.S. dollar and the Japanese yen changes from 140 yen per dollar to 150 yen per dollar. Which of the following is true?
Under a flexible (floating) exchange rate system, the value of a currency is determined by
| Price of a euro (dollars per euro) | Quantity of euros demanded (billions) | Quantity of euros supplied (billions) |
|---|---|---|
| 1.40 | 60 | 100 |
| 1.30 | 70 | 90 |
| 1.20 | 80 | 80 |
| 1.10 | 90 | 70 |
| 1.00 | 100 | 60 |
Hypothetical data for a flexible exchange rate
At the equilibrium exchange rate, about how many euros does one dollar buy?
0 of 4 answered