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Exchange rate primer

Learn about what an exchange rate is and how to determine the cost of goods in another currency.

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Video transcript

- [Instructor] You are already likely familiar with the notion that a dollar in the U.S., a U.S. dollar is not necessarily equivalent to one currency unit in another country, say one Euro. And so if you were traveling to that country, and you are holding dollars, and you needed to exchange those dollars into Euros, you'd say, well how many Euros am I going to get for my dollars? Or if you were European, and you had a certain number of Euro, and you said how many dollars am I going to get for my Euros, you would be thinking about the exchange rate. And it's not just about if you're a tourist or you're traveling, it's also very important if you're an importer and exporter. If you make, say cars, in the United States, where all of your costs are in dollars, but you're selling them in Europe where you're getting your money in terms of Euros, and then you have to convert them back to dollars to pay your costs, well the idea of an exchange rate matters a lot. And so, first let's make tangible what an exchange rate even looks like. And there's many different ways of representing it. The first thing to appreciate, if someone says what's the exchange rate for the U.S. dollar, your next reaction should be, with regards to what other currency? So if I said, what's the exchange rate of the U.S. dollar with respect to the Euro, you could express that as one U.S. dollar, U.S. dollar, is equal to how many Euros? And at the time of this video, it's actually 0.87 Euros. Now another way to express this is one Euro, one Euro is equal to how many U.S. dollars? And if you know this first equation, you can figure out the second one. You would essentially just divide both sides by 0.87. If you divide this by 0.87 you get one. If you divide one by 0.87, you are going to get approximately 1.15. And so at the time of this video, 1.15 U.S. dollars is equal to one Euro. Or another way to think about it is, if you took a dollar and 15 cents in the U.S. and convert it to Euros, you would get one Euro. And there's other ways of expressing it. You could say what is the price of a U.S. dollar, so price of the U.S. dollar in terms of Euro, in terms of Euro. So this is, how much would it cost to buy one U.S. dollar in terms of Euros? Well you could just look at this over here, and you could say, well, one U.S. dollar is going to cost 0.87 Euros. Or you could say 0.87 Euros, Euros per U.S., per U.S. dollar. And if you were to go the other way around, if you wanted the price of the Euro, price of the Euro in terms, terms of the U.S. dollar, U.S. dollar, well that would be the other right way around. One Euro would cost $1.15. So this would be 1.15 U.S. dollars, dollars per Euro. Now with all of this out of the way, let's actually do some calculations. Let's imagine that in the United States a yellow box goes for $20. These yellow boxes are in high demand. Someone from Europe wants to buy one of these yellow boxes, and they need to buy it for 20 U.S. dollars, but they only have Euro. How many Euro would they need in order to buy that box for 20 U.S. dollars. Well if one U.S. dollar is equal 0.87 Euros, then 20 U.S. dollars is going to be 20 times as many Euros. So we could say $20 times 0.87 Euro per dollar. This symbol right over here is shorthand for Euro. And so you are going to get, let's see, that would be 17, approximately, approximately 17.40 Euro. And if it went the other way around. Let's say that red boxes are available for purchase only in Europe for 20 Euro. An American tourist goes there, and wants to figure out how many U.S. dollars would they have to convert in order to be able to pay for one of these red boxes that are 20 Euro? Well here we see one Euro is equal to 1.15 U.S. dollars. So here you would say 20 Euro times 1.15 U.S. dollars, dollar per Euro, and so what is this going to be? This is going to be 20 times 1.15, which is going to be 23 U.S. dollars. 23 U.S. dollars. Now another idea, a related idea to this, is this notion that currencies can appreciate and depreciate. So let's say that the Euro appreciates, appreciates, and it always matters relative to something. So you say relative to the dollar. So the Euro appreciates relative to the dollar. Come up with an exchange rate that would show the Euro appreciating relative to the dollar with this as a starting point. So one scenario where this is happening is if this was where you are starting, one Euro would now be more U.S. dollars, more than 1.15 U.S. dollars. So you have one Euro, would now be equal to, maybe it's equal to $1.20 now. So it's now equal to $1.20. Now if someone said the dollar appreciates relative to the Euro, then it would go the other way around. That might be one U.S. dollars is now equivalent to .9 Euros, or maybe one Euro, or 1.05 Euros. And similarly, if someone says that the Euro depreciates, depreciates relative, relative to the dollar. That's another way of saying that the dollar has appreciated relative to the Euro. So this could be a situation where if the Euro's depreciating relative to the dollar from this place right over here, one Euro, one Euro is now equal to fewer dollars. And maybe it's now equal to $1.05. And with this as a starting point, this would also be a situation where the dollar has appreciated relative to the Euro. So I'll leave you there. This is a primer on exchange rates. It can get a little bit confusing because you're talking for the price of a currency in terms of another currency. But I encourage you to keep thinking about things. Keep doing these little thought experiments in your head, and thinking about, okay, if a Euro is equal to more than a dollar, if something's worth a certain number of Euros, it should be a larger number in terms of dollars. Similarly, if a dollar is less than one Euro, if something costs a certain number of dollars, it should be a smaller number in terms of Euros.