Definition of foreign exchange rate

International Trade and Globalisation

Foreign Exchange Rates

Learning Objective

Define the foreign exchange rate and understand its basic components.

Definition

A foreign exchange rate (or simply exchange rate) is the price of one currency expressed in terms of another currency. It tells us how many units of the foreign currency can be obtained for one unit of the domestic currency, or vice‑versa.

Mathematically, if \$E\$ denotes the exchange rate expressed as domestic currency per unit of foreign currency, then:

\$E = \frac{\text{Domestic currency units}}{\text{Foreign currency units}}\$

Alternatively, when quoted as foreign currency per unit of domestic currency, the rate \$E'\$ is the reciprocal:

\$E' = \frac{1}{E}\$

Key Points

• Exchange rates facilitate international trade and investment by providing a common price basis.
• They can be quoted in two ways:

  • Direct quotation – domestic currency per unit of foreign currency (e.g., \$£0.85\$ per \$1\,\$USD).
  • Indirect quotation – foreign currency per unit of domestic currency (e.g., \$1.18\,\$USD per \$£1\$).

• Exchange rates fluctuate due to changes in supply and demand for currencies, influenced by factors such as interest rates, inflation, and market expectations.

Simple Example

Suppose the exchange rate is \$£0.85\$ per \$1\,\$USD. This means that £0.85 can be exchanged for \$1\,\$USD. To find how many US dollars can be bought with £100:

\$\text{USD} = \frac{£100}{£0.85/\text{USD}} = \frac{100}{0.85} \approx 117.65\ \text{USD}\$

Why It Matters in Economics

1. It determines the cost of imports and the revenue from exports.
2. It affects the competitiveness of a country’s goods and services abroad.
3. It influences inflation, as import prices change with the exchange rate.