By the end of this chapter, you should be able to:
International trade is measured in currencies. A wheat contract may be priced in USD. A shipment from Europe may be priced in euros. A consumer may pay in Omani rials. The exchange rate connects these prices.
Exchange rates affect trade because they change the domestic-currency prices of exports and imports. When a currency depreciates, domestic goods become cheaper for foreign buyers, while foreign goods become more expensive for domestic residents. When a currency appreciates, the opposite happens.
For agricultural trade, exchange rates matter because many food products are imported. A currency movement can change the local cost of wheat, rice, dairy products, animal feed, fertilizer, machinery, and transport services.
An exchange rate is the price of one currency in terms of another currency.
For example, suppose:
\[ ER = 0.386 \text{ OMR per USD} \]
This means that one US dollar costs 0.386 Omani rials.
If a car imported from the United States costs USD 10,000, then the Omani rial price is:
\[ \text{Price in OMR} = 10{,}000 \times 0.386 = 3{,}860 \]
So the car costs OMR 3,860 before transport costs, tariffs, dealer margins, and other charges.
Exchange rates can be quoted in two ways.
| Quotation type | Example | Meaning |
|---|---|---|
| Domestic currency per foreign currency | 0.386 OMR per USD | One US dollar costs 0.386 Omani rials. |
| Foreign currency per domestic currency | 2.59 USD per OMR | One Omani rial buys 2.59 US dollars. |
Both quotations describe the same relationship, but they move in opposite directions.
If the domestic-currency-per-foreign-currency rate rises, the domestic currency depreciates. If the domestic-currency-per-foreign-currency rate falls, the domestic currency appreciates.
Always ask: Which currency is in the numerator?
A rise in OMR per USD means the dollar becomes more expensive in Omani rials. A rise in USD per OMR means the Omani rial becomes more valuable in dollars.
A currency appreciates when it becomes more valuable relative to another currency. A currency depreciates when it becomes less valuable relative to another currency.
Suppose the exchange rate is quoted as euros per US dollar.
| Situation | Exchange rate | Interpretation |
|---|---|---|
| Initial | 1 USD = 1 euro | Baseline. |
| Dollar depreciation | 1 USD = 0.5 euro | The dollar buys fewer euros. The dollar is weaker. |
| Dollar appreciation | 1 USD = 2 euros | The dollar buys more euros. The dollar is stronger. |
If the dollar appreciates against the euro, the euro depreciates against the dollar. Exchange rates are always relative prices.
A weak domestic currency makes domestic goods cheaper for foreigners and foreign goods more expensive for domestic residents.
A strong domestic currency makes domestic goods more expensive for foreigners and foreign goods cheaper for domestic residents.
| Currency movement | Exports | Imports | Likely trade-balance effect |
|---|---|---|---|
| Depreciation | More competitive abroad | More expensive at home | Exports tend to rise, imports tend to fall |
| Appreciation | Less competitive abroad | Cheaper at home | Exports tend to fall, imports tend to rise |
This is the basic trade logic. In practice, the size and timing of the effect depend on contracts, invoicing currency, import dependence, supply capacity, and how strongly consumers respond to price changes.
Suppose a pair of jeans costs USD 30 in the United States.
\[ 1 \text{ USD} = 1 \text{ euro} \]
The price for a European buyer is:
\[ 30 \times 1 = 30 \text{ euros} \]
Now suppose:
\[ 1 \text{ USD} = 0.5 \text{ euro} \]
The same jeans still cost USD 30 in the United States. But for a European buyer:
\[ 30 \times 0.5 = 15 \text{ euros} \]
The dollar depreciation makes US exports cheaper for European buyers.
A weaker dollar does not mean the US producer changed the dollar price. It means the foreign-currency price changed. This is why exchange rates affect international competitiveness.
In a floating exchange-rate system, the exchange rate is determined by demand and supply in the foreign exchange market.
The demand for a currency comes from foreign residents who want to buy that country’s goods, services, or financial assets.
The supply of a currency comes from domestic residents who want to buy foreign goods, services, or financial assets.
For example, demand for US dollars increases when foreigners want to buy US exports, travel to the United States, or invest in US assets. Supply of US dollars increases when US residents want to buy foreign imports, travel abroad, or invest in foreign assets.
The exchange rate moves when demand or supply changes.
| Change | Effect on currency value |
|---|---|
| Increase in demand for the currency | Appreciation |
| Decrease in demand for the currency | Depreciation |
| Increase in supply of the currency | Depreciation |
| Decrease in supply of the currency | Appreciation |
The same logic applies to any currency if the quotation is interpreted correctly.
Exchange rates are affected by many factors.
| Factor | Typical effect |
|---|---|
| Higher domestic interest rates | May increase demand for domestic currency because domestic assets become more attractive. |
| Higher domestic inflation | May reduce demand for domestic goods and weaken the currency. |
| Higher productivity | May improve competitiveness and support the currency. |
| Lower foreign demand for domestic exports | May reduce demand for domestic currency. |
| Higher demand for imports | May increase supply of domestic currency in foreign exchange markets. |
| Expectations | If investors expect depreciation, they may reduce demand for the currency now. |
| Trade barriers abroad | May reduce export demand and weaken the exporter’s currency. |
Capital flows often move faster than trade flows. For this reason, interest rates, expectations, and financial conditions can affect exchange rates quickly.
Countries do not all manage exchange rates in the same way.
| Regime | Meaning | Example logic |
|---|---|---|
| Floating exchange rate | The currency value is mainly determined by market demand and supply. | The central bank does not defend a fixed value. |
| Managed floating exchange rate | The currency moves, but the central bank may intervene to reduce volatility. | The central bank buys or sells foreign currency. |
| Fixed or pegged exchange rate | The government fixes the currency to another currency or basket. | The central bank must defend the official rate. |
A fixed exchange-rate system creates stability, but it also requires the monetary authority to defend the peg if market pressure moves the currency away from the official rate.
Suppose an exchange rate is quoted as domestic currency per US dollar.
If the market equilibrium is 28 domestic currency units per dollar, but the official rate is 25, the domestic currency is overvalued. The central bank must sell dollars and buy domestic currency to defend the official rate.
If the market equilibrium is 85 domestic currency units per dollar, but the official rate is 100, the domestic currency is undervalued. The central bank must buy dollars and sell domestic currency to defend the official rate.
In a fixed-rate system, the official exchange rate is a policy commitment. If market pressure is strong, defending the peg may require foreign-exchange reserves and central-bank intervention.
In the course slides, the Omani rial is used as an example of a fixed exchange-rate system against the US dollar. This is useful for trade analysis because many international commodities are priced in US dollars.
A fixed exchange rate against the dollar reduces direct OMR-USD exchange-rate uncertainty. However, Oman can still be affected by exchange rates through:
So exchange-rate analysis remains relevant even when a country has a fixed rate against a major currency.
The following example shows how the domestic-currency price of an imported good changes when the exchange rate changes.
import pandas as pd
usd_price = 10000
exchange_rates = [0.350, 0.386, 0.420]
fx_table = pd.DataFrame({
"Exchange rate (OMR per USD)": exchange_rates,
"Imported price (OMR)": [usd_price * er for er in exchange_rates]
})
fx_table| Exchange rate (OMR per USD) | Imported price (OMR) | |
|---|---|---|
| 0 | 0.350 | 3500.0 |
| 1 | 0.386 | 3860.0 |
| 2 | 0.420 | 4200.0 |
import matplotlib.pyplot as plt
ax = fx_table.plot(
x="Exchange rate (OMR per USD)",
y="Imported price (OMR)",
marker="o",
legend=False
)
ax.set_xlabel("Exchange rate, OMR per USD")
ax.set_ylabel("Imported price, OMR")
ax.set_title("Exchange rate and import cost")
plt.tight_layout()
plt.show()
The relationship is direct in this quotation. If the exchange rate is OMR per USD, a higher exchange rate means one dollar costs more Omani rials. Therefore, the domestic-currency price of the imported good rises.
Exchange-rate movements can matter strongly for food-importing economies.
Suppose wheat is priced in foreign currency. If the domestic currency depreciates, the local-currency cost of wheat imports rises even if the world price of wheat remains unchanged. This can affect:
This is why trade analysis often needs both commodity prices and exchange rates.
Exchange rates connect world prices to domestic prices. A depreciation usually makes exports cheaper for foreign buyers and imports more expensive for domestic consumers. An appreciation usually has the opposite effect. Exchange-rate regimes determine how freely the currency can move and how much the central bank must intervene.
For agricultural trade, exchange rates are especially important because imported food, fertilizer, machinery, and shipping services are often priced in foreign currency.
A machine imported from the United States costs USD 50,000.