Question

Suppose that last month the U.S. dollar was trading on the foreign-exchange market at \(0.85\) euro per dollar, and today the U.S. dollar is trading at \(0.88\) euro per dollar. Explain what has happened. (LO3) a) The dollar has depreciated and the euro has appreciated. b) The euro has depreciated and the dollar has appreciated. c) Both the euro and the dollar have appreciated. d) Neither the euro nor the dollar have depreciated.

Short answer

b) The euro has depreciated and the dollar has appreciated.

Step-by-step solution

We are given two exchange rates between the U.S. dollar and the euro. Initially, the exchange rate was \(0.85\) euro per dollar, and at the current time, it is \(0.88\) euro per dollar. #Step 2: Determine the change in exchange rates#

We need to determine if the exchange rate has increased or decreased. To do this, we can subtract the initial exchange rate from the current exchange rate: \(0.88 - 0.85 = 0.03\) Since the result is a positive number, this means that the exchange rate has increased from \(0.85\) euros per dollar to \(0.88\) euros per dollar. #Step 3: Analyze the relationship between the two currencies#

If the exchange rate has increased, that means it now takes more euros to buy one dollar than before. In other words, the value of the dollar has increased compared to the euro, and the value of the euro has decreased compared to the dollar. #Step 4: Choose the correct option from the given choices#

Based on our analysis in the previous steps, the correct choice is: b) The euro has depreciated and the dollar has appreciated. As a result, the answer is option b: The euro has depreciated, and the dollar has appreciated.

Key concepts

Currency Appreciation

Currency appreciation refers to an increase in the value of one currency relative to another in the foreign exchange market. When a currency appreciates, it becomes more valuable and can buy a greater amount of foreign currency than before. In the context of the given exercise, where the U.S. dollar increases from €0.85 to €0.88, the dollar has appreciated. This appreciation signifies a stronger dollar; for every dollar exchanged, you would now receive more euros.

For individuals and businesses, this can have various implications. For example, American tourists traveling to Europe could benefit from a stronger dollar as it increases their purchasing power abroad. However, for U.S. exporters, an appreciated dollar may render their goods more expensive and less competitive in foreign markets. Understanding currency appreciation is crucial for investors and companies involved in international trade, as it affects profitability and pricing strategies.

Currency Depreciation

Currency depreciation is the decline in value of a currency in the context of its exchange rate with other currencies. This phenomenon is illustrated in the exercise when the euro's value decreases relative to the dollar, causing the exchange rate to rise from €0.85 to €0.88 per dollar—the euro has depreciated. When a currency depreciates, it weakens against other currencies, meaning it can buy less foreign currency than before.

An immediate effect of currency depreciation is that imported goods become more expensive for the domestic market, which can lead to higher inflation. Conversely, exporters may benefit as their goods become cheaper and more competitive in the global market. In the exercise, a depreciated euro could mean European products become more appealing to international buyers, potentially boosting the European export industry.

Foreign Exchange Market

The foreign exchange market, also known as the Forex or FX market, is where currencies are traded. It's the largest and most liquid financial market in the world, operating 24 hours a day and facilitating the conversion of one currency into another.

In this market, currencies are quoted in pairs, and the rate at which they are exchanged is known as the exchange rate. As seen in the exercise, the exchange rate can fluctuate based on a multitude of factors including economic indicators, market sentiment, and geopolitical events. These rates are determined by the forces of supply and demand: if more people or businesses want a particular currency, its value will typically appreciate, and vice versa.

The ability to analyze and predict currency movements in the Forex market is a valuable skill, particularly for those involved in international business or investment, as it can greatly affect the profitability of cross-border transactions and investments.