No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Fifteen: Issues in International Economics 374 EXCHANGE RATES If you buy an iPhone in Indiana and turn around and sell it in Tennessee, you have a number of issues and complications in your calculations—but one thing you don’t have to worry about is the currency. An iPhone in Indiana is priced in dollars, and so is your sale in Tennessee. But what if you sold it in Mexico? Our previous discussion on England and France abstracted away from the difficulties associated with currency exchange—now we need to touch on that. We ignored exchange rates previously because the economics of exchange is, for the most part, unaffected by the requirement to change currencies. Nevertheless, exchanging currencies can be a cost driver, especially as companies have to consider possible future variation in currency values. As we will demonstrate, it is relatively trivial to convert a value today (a spot transaction), but a bit more complicated to handle transactions in the future. Let’s say you have an older iPod that you want to sell for $75. You put an ad on Craigslist, and a tourist in town for the weekend from Europe offers you 55 Euros. Should you take it? Well, ignoring the transaction costs to convert the tourist’s Euros back to dollars (since you can’t spend Euros in the US), you need to know the exchange rate. Any number of websites can give you today’s exchange rate, such as this one, and you can then do the necessary adjustment. If the current exchange rate is 1 Euro = $1.45, you divide your $75 goal by $1.45 to convert to Euros; you need 51.72 Euros to meet your $75 goal. To see why you can do this, divide both sides of the “1 Euro = $1.45” equation by $1.45, and you get .69 Eur/$ = 1. When you multiply this by $75 (remember, multiplying anything by 1 gives the same result), the dollars cancel and you are left with Euros as the dimension, with the number being 51.72. Since the tourist offered 55 Euros, he or she is offering more than your reservation price of $75. In this case, assuming you can convert the Euros to dollars at zero cost, you should definitely take the offer. If the tourist were offering 55 Euros one year from now, the situation would be entirely different; we’ll learn how to “discount” the future in the next chapter. EXCHANGE RATE REGIMES If countries all used the same currency, this whole issue would go away. When Abraham bought Sarah’s burial ground from the sons of Heth, the price was 400 shekels of silver (noted in Scripture as a commercial standard). The negotiation was no different than if you bought something from a neighboring state, even though Abraham was a foreigner in a foreign land. With a “commodity money” such as gold or silver, there is no exchange rate calculation needed since everyone uses the same money. Almost as easy is when a country fixes its currency against a commodity such as gold. This was the case under the classical gold standard of 1879-1913. Gold coins were exchanged interchangeably with currency in most countries so it was very easy to exchange various gold coins for the bills that represented those coins.