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AOF Business Economics

Lesson 12Currency Systems

Student Resources

Resource Description

Student Resource 12.1 Memo: New Markets for Mercury Shoes

Student Resource 12.2 Reading: Currency Exchange

Student Resource 12.3 Independent Practice: Currency Exchange

Student Resource 12.4 Reading: Currency Fluctuation and Purchasing Power

Student Resource 12.5 Reading: The Big Mac Index

Student Resource 12.6 Writing Frame: Recommendations for Mercury Shoes

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AOF Business EconomicsLesson 12 Currency Systems

Student Resource 12.1

Memo: New Markets for Mercury Shoes

Mercury Athletic ShoesSebastian Oxnard, President & CEO

Memorandum

To: New Consultants

From: Sebastian Oxnard, President & CEO

Subject: Expanding Our Shoe Sales and Manufacturing to Overseas Markets

Mercury Athletic Shoes has shown significant growth over the past five years. Our board of directors is considering expanding the sales of our shoes to a number of overseas markets.

In order to make a decision whether to expand and, if so, to which countries, we would like you to study the impact on our company of expanding in each of the five countries represented in the table below. I’ve included currency exchange data on each country in the table. Please analyze the data and give us your recommendations.

In order to help some of our board members (who are not experts in currency exchange rates) to understand your reasoning, we would like you to cover the following in your report:

Which country is the best place for us to expand our market, based on current currency exchange rates and purchasing power? Explain in detail why you selected that country and why you think people in that country are more likely to buy our shoes than people in other countries you did not select.

Which country is the best place for us to open a new manufacturing plant, based on exchange rates and purchasing power? Explain in detail why you selected the country and why you think this would be a more affordable place for us to manufacture our shoes than the other countries you did not select.

Given our average shoe price in the United States (per pair) of $100, in US dollars, what would it cost a consumer of each country on our list to buy our shoes if (a) we based the local price in each country on converting US $100 into local currency, and (b) if we set the local price in each country at the amount of local currency that has the same purchasing power, locally, that US $100 does in the United States?

What wage paid in local currency to workers at a factory in each country would have the same purchasing power as the $10/hour average wage paid in the United States?



The board of directors will be evaluating your recommendations based on the following minimum criteria:

You demonstrate an understanding of an exchange rate, trade, and purchasing power.

You explain how fluctuating exchange rates affect businesses and individuals.

You provide an explanation of why exchange rates change over time.

Your recommendations are written in a manner that shows an understanding of communications expectations in the workplace.

Currency Exchange Rate as of December 2015

$1 US In US Dollars

Brazilian Real 3.88 $0.26

European Union Euro

0.91 $1.10

Indian Rupee 67.09 $0.01

Mexican Peso 17.35 $0.06

Thai Baht 36.10 $0.02




Reading: Currency Exchange

This presentation provides an introduction to foreign currency exchange and how it impacts increasingly globalized businesses.

In this presentation you’ll learn:

• How currencies around the world are exchanged

• Who is doing the exchanging

• The importance of currency exchange for multinational businesses



Just like other commodities, currencies (money) can be bought, sold, and exchanged for an agreed-upon amount.

Though currencies are in many ways like other commodities, they do have some very distinctive traits:

• Currencies are specially created to facilitate trade and commerce.

• They are easily exchanged for other currencies or for other commodities, at widely agreed-upon values.

To illustrate how currencies are different from most other commodities, imagine trying to sell or exchange a commodity like a barrel of oil for several bags of groceries. While the oil has an agreed-upon value, it isn’t easy to find someone willing to buy or exchange for it. Of course, people do buy and exchange barrels of oil, but it isn’t as easy or as common as exchanges for currencies.

Most countries have their own currencies, though sometimes groups of countries share a currency, like the countries in the European Union that share the euro. Sometimes countries may agree to use another country’s currency (for example, Panama has decided to use the US dollar as its own currency).



Individuals, businesses, and governments exchange trillions of dollars’ worth of currency each day, making the foreign currency exchange (or forex) market the world’s largest. All of this market is over the counter, which means that brokers and traders deal directly with each other and there is no central exchange. Nevertheless, a large proportion of the world’s currency trading occurs in just three major cities: London, New York, and Tokyo.

Currencies are traded through spot trading, which means the exchange happens within a day or two at the most, at the exchange rate prevailing at the moment the exchange was agreed. They are also traded through futures contracts, where traders agree upon a price to exchange currencies at a set time in the future, for example three months out.

Huge multinational commercial banks and investment banks do the bulk of currency trading, so they effectively determine the sell and buy price of currencies through their negotiations. Other traders follow these prices closely. While large banks conduct most of the world’s currency exchange trade, other entities also buy and sell currencies on a large scale, including governments, central banks, hedge funds, managed investment funds, and multinational corporations.

Of course, individuals exchange currencies whenever they visit other countries or if they work in a foreign country and send money home.



Like the prices of other commodities, exchange rates are determined by the interaction of supply and demand. The more people want to buy a particular currency, generally the higher its price. As a currency rises in value, demand falls, until demand and supply are brought into balance (equilibrium). This keeps currencies from rising in value indefinitely.

However, most currencies don’t operate in a pure free-market situation. Governments and their associated central banks (such as the Federal Reserve in the United States) track exchange rates closely because of the very large impact they have on the economy. From time to time, governments and central banks use various strategies to manipulate the value of their currency to keep it higher or lower than it would otherwise be. Sometimes central banks intervene directly in the foreign exchange markets, buying or selling currencies in an attempt to influence exchange rates. Some countries such as Japan and the United States manipulate the money supply to affect interest rates, which also impacts exchange rates.

Since the 1970s, when the exchange rates of the advanced economies in the world were first allowed to float at levels determined in the market by supply and demand, it has been fairly unusual for central banks in those countries to intervene directly in the foreign exchange markets. There are other countries, however (notably China), where the government and the central bank very actively intervene to hold the exchange rate of their currency within a narrow range. This practice is controversial when it holds down the exchange rate of a currency (makes it artificially weak), as in the case of China’s currency the renminbi (RMB). Many people view this as creating an unfair competitive advantage in exporting by creating cheap labor in the offending country.



Why are some currencies more in demand than others?

As with any commodity, a lot of demand is from financial traders (or speculators) who want to bet that a particular currency will increase in value and another will fall.

Demand also comes from investors wishing, for example, to set up a factory in a country and needing local currency to pay local costs. Such investors tend to invest where the government is stable, inflation is low, and the economy is growing fast. This results in strong demand for such countries’ currencies, causing them to hold or gain value. Investors shy away from unstable countries with high inflation and slow or no economic growth. Demand also comes from other countries perceiving a country and its currency as a safe haven relative to the rest of the world. This was true for the United States for the second half of the 20th century.

There is another big source of demand and supply for currencies. When a business in the United States exports a product, the customer pays in local currency. The seller has expenses in US dollars, so it converts its euros into dollars—that is, the seller sells euros in exchange for dollars. This adds to the supply of euros and the demand for dollars. Conversely, if a US company imports products from Germany and pays for them in euros, it buys those euros from the bank and pays in dollars. This adds to the demand for euros and the supply of dollars. Currently, the world’s most traded currencies are:

• United States dollar: 85% of daily transactions

• European Union euro: 39% of daily transactions

• Japanese yen: 19% of daily transactions

• British pound sterling: 13% of daily transactions



In our increasingly globalized economy, more and more businesses are selling their products and services in foreign countries and/or are purchasing resources or manufacturing products in foreign countries. In each of these cases, currencies are exchanged.

Hopefully, these businesses are making a profit, and if they are, they are likely making choices about which countries and currencies to invest their earnings in. Companies want to invest money in countries and currencies that are likely to retain their value and even increase in value. If their home currency is unstable or losing value, businesses will usually seek another currency in which to invest their money.

Because so much money is flowing between countries, even the change of a few percentage points in value between currencies can mean a big absolute change in costs or earnings.



One of the key roles of a business economist is to help companies understand how currency exchange rates will impact their bottom line.

In addition to figuring out the costs of producing and selling goods and services, those businesses that sell or produce in foreign countries must also understand the impact of currency exchange rates on their businesses.

For example, when Microsoft sells billions of dollars of its software overseas, it must know how and when to best exchange the large amounts of currency that changes hands.

As the world grows smaller, with more container ships crossing the oceans and cargo planes transporting valuable commodities in hours instead of months, more and more businesses are buying resources, manufacturing goods, and selling goods and services in other countries.




Independent Practice: Currency ExchangeStudent Name:_______________________________________________ Date:___________

Directions: For this homework activity, use the table of currency exchange rates below to help you answer questions about consumers and businesses conducting transactions involving foreign currency.

1 US dollar = 3.88 Brazilian reals 1 Brazilian real = 0.26 US dollars

1 US dollar = 0.91 European Union euros 1 European Union euro = 1.10 US dollars

1 US dollar = 67.09 Indian rupees 1 Indian rupee = 0.01 US dollars

1 US dollar = 17.35 Mexican pesos 1 Mexican peso = 0.06 US dollars

1 US dollar = 36.10 Thai baht 1 Thai baht = 0.02 US dollars

1. Carlos Zermeño moved to the United States from Mexico 25 years ago. Today, Carlos is the manager of one of the largest banks in his town. Every month, Carlos sends $100 to his elderly parents in Mexico. Using the above exchange rates, how much money does Carlos send to his parents each year in Mexican pesos?

2. Latoya and her friend Jasmine are taking a special trip to Europe to celebrate graduating from college. In preparation for the trip, they want to exchange $500 each in euros so they’ll have money easily available to spend when they land at Paris’s Charles de Gaulle airport. How many euros will they each get for their $500?

3. Amy Lee is in a bazaar in India, and she wants to buy a beautiful silk sari. After haggling with the merchant, she has brought the price down to 3,750 Indian rupees. She saw a similar sari in a shop in Berkeley for $150. Is the sari in this bazaar a good deal? Why or why not?



4. Mike Tevee is an amateur investor who has started speculating in currencies. A year ago he heard a rumor that the Thai baht was about to rise in value because of a change in government and he bought 150,000 baht for $3,000. Given the value of the baht today, did Mike make a good investment?

5. The Mercury Athletic Shoes company has a factory in Thailand. Each month it must pay $500,000 in salaries to employees at the factory. How many Thai baht must it purchase in order to make this payment?

6. The American Furniture Company buys tons of renewable hardwood each year from Brazil. This year it has allocated $400,000 to purchase the wood. How much is this in Brazilian reals? If the value of the real goes up to 0.46 of a US dollar, how much more, in dollars, will the American Furniture Company have to pay for the same amount of wood?

7. Zeppo Automobiles is a new car company based in Germany. This year it made a profit of $10 million on cars sold in the United States. It converted these dollars into euros. How many euros did it make in profits on these sales?

Extra Credit:

8. The Delish International Food Company decided to protect its earnings from currency fluctuations by investing in several currencies. It invested $1 million in the euro, $1 million in the US dollar, and $500,000 in the Brazilian real. The dollar fell 5%, the real rose 10%, and the euro stayed the same. How much money, in US dollars, did the company make or lose? Would it have been better to keep all of the money in dollars?




Reading: Currency Fluctuation and Purchasing Power

This presentation explores how economists measure what people’s incomes in different countries are really worth by looking at their purchasing power. Businesses must understand purchasing power in order to make decisions about where to sell their products, how to price their products in different countries, and where to open new manufacturing plants.

One important role of the business economist is to help companies understand these economic data.



All businesses rely on individuals, or companies and other organizations that are also customers, to buy their products or services. When people have more money to spend (or believe they will have more money to spend because of expectations of future earnings or wealth), business is generally better and profits go up. When people feel less able to spend, they obviously tend to purchase less.

People in each country have a different sense of how much disposable income they can spend. In some wealthy countries, most people are able to purchase a wide variety of goods and services, while in many poor countries, most people cannot afford more than basic food and housing, with little or no money left over for other goods.

Economists try to understand the relative ability of consumers in different countries to purchase goods by using a concept known as purchasing power.



Using purchasing power as a way to measure living standards between nations is useful, because it offers a more accurate picture of incomes and ability to spend than just looking at cash incomes. To measure people’s real incomes, it’s important to look not only at how much money they make but also what that money can buy (its purchasing power).

Consider China, where the average worker makes far less than a similar worker in the United States. On paper, it would seem that the US worker is much better off. But if one looks at costs in China, and how much Chinese workers have to spend on necessities such as food, housing, health care, and transportation—the purchasing power of their income—the gap between the real incomes of workers in China and the United States turns out to be considerably smaller. Chinese and American incomes expressed in terms of purchasing power (often referred to as real income) are less far apart than a calculation based on exchange rates would suggest.

At the other extreme, workers in Japan earn more than their American counterparts, but the cost of living is much higher in Japan, making the purchasing power of Japanese workers less than that of their American counterparts.



One way that economists measure purchasing power is by comparing how much an identical set of goods (“basket”) costs in the currencies of other countries.

Economists have found that in low-wage countries, goods and services that are produced locally tend to be less expensive than in high-wage-earning countries. By contrast, imported, or tradable, goods such as electronics, machinery, and imported foods, tend to have broadly similar prices around the world.

For example, getting a haircut in India, a relatively low-wage country, would be inexpensive compared to a haircut in a high-wage country. An iPod, however, would cost about the same, after allowing for currency conversions at the going exchange rates, in both countries. This would mean that an iPod would be out of reach for many wage earners in India.

As a side note, economists can form an impression of whether a currency may be under- or overvalued by checking to see if highly tradable items such as an iPod or a Big Mac cost the same in local currency as they cost elsewhere. Economic theory suggests that such items should tend to have the same price across currencies. If there are big differences in price, the currencies may be under- or overvalued. If a currency really is overvalued, it may not be attractive to investors and may lose value over time.



The purchasing power in different countries is continually changing as economies change.

Purchasing power can be weakened by a number of causes:

• Inflation (a situation where prices of many goods and services go up). If wages remain the same, consumers must spend more of their income for basic necessities, leaving less money available for other purchases.

• Currency devaluation means that the currency is worth less compared with other currencies. This means importers of goods have to charge higher prices in local currency in order to pay what their foreign supplier is charging them in the foreign currency. This makes imported goods more expensive for consumers. Currency devaluation also makes it more expensive for them to travel to other countries, since they have to change more of their own currency to get the same amount of foreign money.

• Countries that are heavily dependent on imported items, especially for necessities such as food and fuel, can be hit hard by currency devaluation, as consumers must pay more for imported necessities. This means that their wages are worth less. In other words, the purchasing power of their income has been reduced.



Businesses are affected by inflation, devaluation, and rising import costs as well.

Where inflation is high, rising prices mean consumers’ income no longer buys the same amount of goods and services as it used to. Employees may put pressure on their employers for higher wages to be able to afford the rising cost of living.

When a currency’s exchange rate falls, this means it can buy less of other currencies in exchange (that is, the currency is devalued). That generally increases the price of imported goods and services expressed in local currency. From the consumer’s point of view, that’s inflation.

In much the same way, if a company must purchase inputs from overseas, those inputs will generally be more expensive to buy in local currency. Businesses that depend heavily on materials and resources from other countries can be especially hard hit if the local currency is devalued.

When a currency is devalued (that is, its exchange rate falls), any investments a business has made in that currency tend to lose value as well. However, currency devaluation is not harmful for all businesses. Those that produce goods with local resources and labor but export their goods or services to countries with stronger currencies may even benefit from currency devaluation.

As you can see, understanding how currencies can change value, and the impact of purchasing power, is a very important thing for businesses to understand.




Reading: The Big Mac IndexStudent Name:_______________________________________________ Date:___________

Directions: Below is information about Economist magazine’s Big Mac Index (“BMI”). Read it carefully, and as you read, think about these questions. When you are finished, write down your answers to the questions.

Given the exchange rates from the currency exchange activity (Student Resource 12.3) and the costs of Big Macs in the five different countries listed at the end of the article, which of the currencies look overvalued? Which look undervalued?

How much does a Big Mac in Thailand cost in US dollars?

What might make the Big Mac served on Reunion Island so expensive?

In 1986, Economist magazine wanted an informal and fun way of measuring something called purchasing power parity (“PPP”). PPP suggests that the exchange rate between two currencies should naturally adjust so that a sample basket of goods and services costs the same in both currencies. After some thought, the editors came up with the idea of publishing an annual Big Mac Index. The index uses the familiar idea of the cost of a basket of goods, but the good in this case is a McDonald’s Big Mac, which is sold around the world in pretty much the same form everywhere. Additionally, because franchisees have the power to negotiate ingredient costs locally, the price of the Big Mac eventually reflects, to some extent, the costs of local ingredients. For these reasons, the index enables a very rough, but useful, comparison between the local purchasing power of many different countries’ currencies.

The way it works is this: Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in Country A (in its currency) by the price of a Big Mac in Country B (in its currency). The result is then compared with the actual exchange rate. If the BMI is lower, that may be a clue suggesting that Country A’s currency is undervalued compared with Country B’s currency. Conversely, if the BMI is higher than the actual exchange rate, it may be a clue suggesting that Currency A is overvalued.

For example, suppose the price of a Big Mac is $2.50 in the United States and £2.00 in the United Kingdom; thus, the PPP “exchange rate” is £2.00/$2.50 = 0.80 pounds/dollar. If, in fact, £0.60 buys $1 in the foreign exchange market (which is not far off the actual exchange rate as of the date this is written, but exchange rates keep varying), then if you go by this very do-it-yourself method, it looks as if the US dollar might be undervalued by £0.20 (£0.80 - £0.60), or about 25% (£0.20/£0.80).

LimitationsThe Big Mac Index is not a perfect way to measure the local purchasing power of a currency and the local purchasing power of a currency does not necessarily tell us what its exchange rate is going to be.

In many countries, eating at international fast-food chain restaurants such as McDonald’s is relatively expensive in comparison to eating at a local restaurant. Also, the demand for Big Macs is not as large in countries such as India as it is in the United States. Social status of eating at fast-food restaurants like McDonald’s, local taxes, levels of competition, and import duties on selected items may not be representative of the country’s economy as a whole.

While trade tends (very broadly speaking) to equalize the prices of internationally tradable goods such as iPods across countries, there is no theoretical reason why costs of nontradable goods and services such as property costs should be equal in different countries. For these reasons—and many others—PPPs can be different from market exchange rates.



Nevertheless, economists continue to be fascinated by the Big Mac Index and thinking about it can give some insights into what’s going on economically in the world. The PPP also demonstrates that economics, while useful, is not an exact science!

Some FiguresFive most expensive Big Macs (based on price in local currency as of July 16, 2015, converted to US dollars at market exchange rates):

Switzerland: $6.82

Norway: $5.65

Sweden: $5.13

Denmark: $5.08

United States: $4.79

Big Mac costs in different currencies as of July 16, 2015:

Brazil: 13.50 reals

EU: 3.70 euros

Mexico: 49 pesos

Thailand: 108 baht

Canada: 5.85 Canadian dollars




Writing Frame: Recommendations for Mercury ShoesStudent Name:_______________________________________________ Date:___________

Directions: Fill in this writing frame using the information you’ve gathered during this lesson.

Dear Members of the Mercury Athletic Shoes Board of Directors,

I am pleased to provide this information to help you in deciding where to expand the sales and

manufacture of our athletic shoes.

I believe that based on current currency exchange rates and purchasing power, the best country/region

for us to expand our sales into is . The potential for sales there is large because

Given our average shoe price of US $100, the relative cost to a consumer in the recommended country,

based on his or her purchasing power, is . However, if the value of the currency rises, compared

with the US dollar, then I predict our sales will rise/fall, because

Some things that may cause the currency to fluctuate include

Of the different possible locations to build our new factory, based on currency exchange rates and

purchasing power, I recommend ________________________________________________________ .



Factory workers there on average make per month. With their purchasing power, this is

equal to US dollars per month. Given our average wage of US $10/hour, this would be

equal to US dollars, given their purchasing power.

If the US dollar rises/falls against this currency, then it will become more/less expensive for us to operate

our plants in this country because

Sincerely,


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curriculum.naf.orgcurriculum.naf.org/packaged/assets/downloads/finance... · Web viewAmy Lee is in a bazaar in India, and she wants to buy a beautiful silk sari. After haggling with