understanding the dollar and exchange rates

It is a common talking point by laymen that the US dollar should trade at par or greater than the Canadian dollar, the British Pound or the EU dollar. If they wish to make the point that the EU is doing better than the US, they might ask how many Euros can one get for a dollar (the current exchange rate is $0.74 USD per Euro). The thing about this is that nominal monetary denominations are absolutely worthless in determining the relative strengths of economies. In reality, there is no reason to assume any basic unit of money should be equal to a unit of money in another country. The value of money is determined by the output of society relative to the amount of currency in circulation (and how fast it circulates). If a nuke blew up the entire EU, the Euro would quickly plummet in value (maybe trading at millions per US dollar).

Americans get stuck in a strange mindset that a dollar should be a dollar of a foreign currency anywhere else in the world. It should not. Where it is close (like the US and Canada), it is coincidental. An American dollar can get 13 Pesos in Mexico. That does not mean that the American can then go buy 13 Double Cheeseburgers from the dollar menu at McDonald’s. In fact, it turns out that the price of McDonald’s products are subject to the law of one price, and are roughly the same amount of money (converted into any currency) all over the world. The Economist publishes regularly the Big Mac index to illustrate this.

Converting the Euro price of a Big Mac to American currency results in a price of $4.66. The American price of a Big Mac currently averages $4.56. By my account, the dollar is doing better than the Euro because we can by more things with the same amount of money (while at the same time making more money per person). The current exchange rate does not matter as much as the products people can buy with the same money.

This is why economists look at changes in exchange rates instead of nominal exchange rates. And even that can be deceiving.

About christopher fisher

The blog is meant for educational/entertainment purposes. All material can be used and reproduced in any length for any purpose as long as I am cited as the source.
This entry was posted in Economics, prices, Trade. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s