Exchange rate primer | AP Macroeconomics | Khan Academy

You're already likely familiar with the notion that a dollar in the US, a US dollar, is not necessarily equivalent to one currency unit in another country, say one euro. So, if you were traveling to that country and you are holding dollars, and you need 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 euros, and you said, "How many dollars am I going to get for my euros?" you would be thinking about the exchange rate. 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, then you have to convert them back to dollars to pay your costs.

Well, the idea of an exchange rate matters a lot. So first, let's make tangible what an exchange rate even looks like. There are many different ways of representing it. The first thing to appreciate, if someone says, "What's the exchange rate for the US dollar?" your next reaction should be, "With regards to what other currency?"

So if I said, "What's the exchange rate of the US dollar with respect to the euro?" you could express that as "One US dollar is equal to how many euros?" At the time of this video, it's actually 0.87 euros.

Now, another way to express this is, "One euro is equal to how many US dollars?" 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 1. If you divide one by 0.87, you're going to get approximately 1.15.

So, at the time of this video, 1.15 US dollars is equal to one euro. Another way to think about it is if you took a dollar fifteen cents in the US and converted it to euros, you would get one euro. There are other ways of expressing it; you could say, "What is the price of a US dollar?" So, the price of the US dollar in terms of euros. This is how much would it cost to buy one US dollar in terms of euros.

Well, you could just look at this over here and you could say, "Well, one US dollar is going to cost 0.87 euros," or you could say "0.87 euros per US dollar." If you wanted the price of the euro in terms of the US dollar, well, that would be the other way around; one euro would cost a dollar fifteen cents.

So, this would be 1.15 US 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 twenty dollars. 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 twenty US dollars, but they only have euros.

How many euros would they need in order to buy that box for twenty US dollars? Well, if one US dollar is equal to 0.87 euros, then twenty US dollars is going to be 20 times as many euros. So, we could say, "20 dollars 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 approximately 17.40 euro.

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 US dollars they would 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 US dollars. So here you would say, "20 euro times 1.15 US dollars per euro."

So what is this going to be? This is going to be 20 times 1.15, which is going to be 23 US dollars, 23 US 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 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.

One scenario where this is happening is if this was where you are starting. One euro would now be more US dollars—more than 1.15 US dollars. So, you have one euro that would now be equal to maybe it’s equal to a dollar 20. Now it’s now equal to one dollar 20 cents.

Now, if someone said the dollar appreciates relative to the euro, then it would go the other way around. That might be one US dollar is now equivalent to 0.9 euros or maybe one euro or 1.05 euros. Similarly, if someone says that the euro depreciates 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 is depreciating relative to the dollar from this place right over here, 1 euro is now equal to fewer dollars. So maybe this is now equal to a dollar five, 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 about 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.