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Module 14: The Price of a Passport - Exchange Rates

If an interest rate is the price of time, an Exchange Rate is the price of place. It dictates how much one nation's currency is worth relative to another. Because the US Dollar is the global reserve currency, its exchange rate dictates the flow of global trade.

1. Appreciation vs. Depreciation

  • Appreciation: The US Dollar becomes stronger (e.g., changing from 1 USD = 0.85 EUR to 1 USD = 0.95 EUR). You need fewer dollars to buy foreign goods .
  • Depreciation: The US Dollar becomes weaker. Your buying power for imported goods drops .

2. What Moves the Needle?

  • Interest Rates: If the Federal Reserve raises interest rates, global investors flock to US Treasury bonds to capture high, risk-free yields. To buy those bonds, they must purchase US Dollars, causing the dollar to appreciate.
  • Inflation: Countries with low inflation preserve their purchasing power, leading to currency appreciation.
  • Safe Haven Speculation: During global wars or financial panics, capital floods into the US Dollar seeking safety, driving up its value regardless of domestic economic conditions.

3. The Impact on Corporate Earnings

For a US investor, currency strength is a double-edged sword.

  • Strong Dollar: Excellent for US consumers buying imported electronics or traveling to Europe. However, it hurts multinational US corporations (like Apple or Microsoft). When they sell software in Japan, those Euros or Yen convert back into fewer US Dollars, suppressing their reported earnings.

Case Study: Purchasing Power Parity (PPP) & The Big Mac Index PPP suggests that exchange rates should naturally adjust so that a standard "basket of goods" costs the exact same across borders .

  • Analysis: The Economist uses the "Big Mac Index." If a Big Mac costs $5 in New York but the equivalent of $3 in Tokyo, PPP theory suggests the Japanese Yen is fundamentally "undervalued" against the Dollar and should eventually appreciate.

Self-Assessment Quiz

  1. If the Federal Reserve unexpectedly raises interest rates by 1%, what will likely happen to the value of the US Dollar relative to other currencies, and why?
  2. Why does a sharply appreciating US Dollar often negatively impact the stock prices of large US manufacturing exporters?