DR. MATTHEW HALLORAN: Hello, this is Professor Matthew Halloran, Assistant Professor of Economics at Penn State Worthington Scranton. I'm here to talk to you about the effect of exchange rates on the foreign purchasing costs of Americans. How when exchange rates change, it changes how expensive it is to buy goods produced overseas.

The exchange rate-- which I'm calling the letter e throughout this presentation-- between the US dollar to foreign currency states the number of units of the foreign currency that can be purchased by one US dollar. In this table here, I show exchange rates for the US dollar two years ago in April 2008, and then currently in the current month. And these are stated again in the number of units of the foreign currency that can be purchased by one US dollar.

So for example, you see from these numbers that for currencies like the European Euro, the UK Pound, where this number is less than one, that means that a unit of the Euro or the Pound is more valuable than the US dollar. And similarly when this number is bigger than one, like the other numbers, then a unit of the foreign currency is less valuable per unit than the US dollar.

You see recently the Canadian Dollar and the Swiss Franc have been almost equivalent in value to the US dollar per unit. These currencies are just chosen because they're important currencies throughout the world.

I think economists tend to think of three really important currencies in the world as being the US Dollar, the European Euro, and the Japanese Yen, which simply represent three big areas of the world, the sort of the Americas, Europe, and then the Far East. But there's some other currencies here I show as well.

We show the UK Pound which is Great Britain's currency, which is one of the oldest currency in the world. The Canadian Dollar is important to Americans, because Americans are very close to Canadians and do a lot of interactions with Canadians.

The Chinese Yuan is very relevant these days because of a lot of trade that happens, especially with manufactured goods between Americans and Chinese people. And the Swiss Franc is often used as an example currency just because of Switzerland's historic importance in finance.

Today, we'll focus directly on the British Pound as an example. And you see that in April 2008, the table shows that the exchange rate was 0.505 Pounds per Dollar. This means that in April 2008, a US Dollar could buy 0.505 British Pounds or about half of a British Pound, or similarly a British Pound would trade for about $2.

Exchange rates can be either what's called a floating exchange rate or a fixed exchange rate. The American Dollar is allowed to float. So the Americans don't ever fix the Dollar exchange rate, but sometimes it can be fixed by the other country.

A floating exchange rate, however, is completely determined on world currency markets. If the exchange rate floats, it means both countries involved in the comparison allow their currency to float. A floating exchange rate, the exchange rate changes, and it's determined on currency markets where entities like banks or governments-- often individuals-- will buy and sell currencies. And depending on the supply and demand for these currencies of the world market, the exchange rate will fluctuate.

For example, the US Dollar exchanges in a floating way with the European Euro, the UK Pound, the Japanese Yen, the Canadian Dollar, many other currencies are at these floating rates. A fixed exchange rate means-- and the important word is fixed-- the exchange rate is held in some fixed range by the actions of a government. For example, the Chinese Yuan is fixed relative to the US Dollar, and only allowed to fluctuate in a certain range.

This is accomplished by the Chinese government's central bank manipulating the currency markets in order to maintain this fixed rate. They'll accomplish this, for example, if they want to devalue the Chinese Yuan relative to the US Dollar. They'll sell off reserves that they own of the US Dollar to essentially devalue the US Dollar over to the Yuan.

And similarly, if they want to make the Yuan more valuable, they will sell off the US Dollar. And if they want to make the Yuan less valuable, buy the US Dollar. And these are ways that they can accomplish keeping the rate in a certain range.

Fixed exchange rates have very important macroeconomic implications. But they're not really relevant to the question we're looking at today, which is how exchange rates changing can affect borrowing costs, because fixed exchanges don't change very much, at least from a standpoint of a single person buying and selling goods.

So what a fixed rate exchange rate does from the standpoint of individuals it makes costs, say for Americans buying Chinese goods, very predictable, relatively constant, and much easier to predict. Because, again, the rate is not allowed to change very much.

So we'll focus directly on foreign exchange rates in which the fluctuations in exchange rates are much larger and more predictable. Because, again, they're changing all the time on currency markets. When exchange rates fluctuate, the cost of Americans buying foreign goods can change quite significantly.

So as an example, assume that you went to London for three nights on business in 2008. For simplicity, let's assume that your hotel charges 100 Pounds per night. And we just want to figure out how many Dollars would you have spent for this three night stay?

So we're just going to convert the cost of the stay in Pounds to what it's cost would be in Dollars. To accomplish that, we just use the exchange rate that prevailed in 2008 which, again, is 0.505 Pounds per Dollar.

So for the three night stay, you would spend 300 Pounds. We just want to figure out what that would be in Dollars in this case. To figure that out, you would just use the equation I show below which is that the price of this stay in Dollars would be the price of the stay in Pounds divided by the exchange rate. Dividing by exchange rate will convert the Pound price into a Dollar price.

In this case, we would take the Pound price of 300 Pounds divide it by the exchange rate which is 0.505. And when you do that, you get a Dollar price of $594.06. That means that the hotel stay would cost $594.06 in Dollars.

Now we saw in the previous table that the current exchange rate in 2010 between the US Dollar and the British Pound is different than it was two years ago. The exchange rate is now 0.657 Pounds per Dollar. You see this number is bigger than 0.505.

That means that the US Dollar has appreciated in value relative to the British Pound since 2008. And you see that now one US Dollar now buys a larger number of British Pounds than two years ago.

So that means that in the last two years, the US Dollar is now worth more relative to the Pound than it was two years ago. So the question we can then ask is if you were to go to London now, and again have a three night stay and it cost 300 Pounds, would this stay cost more or less in Dollar terms than it did two years ago in 2008?

And you should understand that this stay would now-- this currently would now cost fewer Dollars because, again, the Dollar is more valuable to the Pound. So in this case, what would the spending on the hotel stay be in 2010?

We'll use the same equation again. So the price in Dollars is going to equal the price in Pounds, which we're assuming stays the same, and we're going to divide that by the exchange rate to convert the price in Pounds to the price in Dollars. In this case, the Pound price is 300 Pounds again. We'll divide that by the exchange rate, 0.657.

And this time, since we're dividing by a bigger number, we'll get a smaller number of Dollars. That is going to be $456.62. So you see that, at the different exchange rate, the 300 Pound hotel stay cost a significantly fewer number of Dollars than it cost two years ago. This little demonstration shows that exchange rates affect the cost of buying foreign goods.

m like the example, the US Dollar appreciates, or becomes more valuable relative to foreign currencies, foreign goods become cheaper for Americans to buy. And similarly, if instead the US Dollar had depreciated, or become less valuable relative to foreign currency, that would mean that foreign goods become more expensive for Americans to buy. At the same time, American goods become cheaper for foreigners to buy.

SPEAKER 2: Just wrap up I--

DR. MATTHEW HALLORAN: And that--

SPEAKER 2: --it's not on right now. Go for it.

DR. MATTHEW HALLORAN: And that is all I have. Thanks. Again, my name is Professor Matthew Halloran at Penn State Worthington Scranton.