How Much Is Your Money Worth Abroad?

This post, originally published Nov. 29, 2023, has been updated with an infographic and minor changes to numbers in the text to correspond with the infographic information.

You have decided to vacation in Switzerland. You buy your plane ticket, book the hotel and plan various excursions to see all Switzerland has to offer. After a long flight, you land exhausted and need a pick-me-up.

However, you forgot to convert your U.S. dollars into Swiss francs, and the bank will not open for another hour. Fortunately, you find a coffee shop that takes both U.S. dollars and Swiss francs, but something is off. The cup of coffee costs 2 francs, but it’s 2.27 in U.S. dollars. The coffee has the same value, but the currencies you use to purchase the coffee have different values. Why is the dollar-price of coffee higher? This is where exchange rates come in.

Exchange Rates Explained

An exchange rate is the value of one currency in terms of another. For example, this Sept. 11, 2023, FRED Blog post shows the value of the U.S. dollar in terms of Swiss francs. That is, an exchange ratio is the price of one currency (a base currency) in terms of another currency (the quote currency). This means we read an exchange rate as this:

1 base currency = some value of the quote currency

So, in our example, the U.S. dollar is the base currency, and the Swiss franc is the quote currency: dollar/franc. Let’s say the currency exchange rate is 0.88 for the dollar/franc. This means one U.S. dollar is equal to 0.88 Swiss francs. The inverse of this exchange rate is one franc is equal to $1.14.1. The inverse of an exchange rate is also a perfectly valid exchange rate, but it is customary to quote a particular exchange rate in a particular “direction.” That is, it is customary to quote the exchange rate involving the U.S. dollar and the Swiss franc in terms of U.S. dollars per Swiss franc. We can interpret this exchange rate as one U.S. dollar is worth less than one Swiss franc.

What Is Meant by “Stronger” or “Weaker” Currency?

Two words commonly used when comparing two currencies and their exchange rate are “weaker” and “stronger.” As noted in a 2015 Page One Economics essay, a currency “strengthens” when it can purchase more of the other currency than before. Similarly, a currency “weakens” when it can purchase less. In this case, if the U.S. dollar strengthens, you would be able to purchase more francs than previously, and if it weakens, you would be able to purchase fewer.

Going back to our coffee example, if you had 10 francs and $10, and the coffee cost 2 francs or $2.27, you could purchase five cups of coffee with the Swiss francs but only four cups with the U.S. dollars. This highlights how one Swiss franc has a higher purchasing power than one U.S. dollar.

We also use “stronger” and “weaker” to describe fluctuations in the exchange rate. If a ratio declines in value, we say the quote currency is getting stronger relative to the base currency, or the base currency is getting weaker relative to the quote currency.

For example, if the dollar/franc ratio goes from 0.88 to 0.75, it takes more dollars to purchase a Swiss franc ($1.33 vs. $1.14); the U.S. dollar weakened against the Swiss franc. If the dollar weakens against the franc, it takes more dollars to buy Swiss goods and fewer francs to buy U.S. goods. Using the coffee example, the price of the coffee was 2 francs or $2.27 when the exchange rate was 0.88. But since the U.S. dollar weakened against the franc, the price for the coffee is still 2 francs but now costs 2.67 in U.S. dollars.

Likewise, say the exchange rate rose from 0.88 to 0.95. Even though one U.S. dollar is still weaker than one Swiss franc, we say the dollar strengthened against the franc relative to when it was 0.88. Now, the coffee that costs 2 francs costs only $2.11. Thus, the dollar gained a higher purchasing power against the franc.

Exchange Rate Influencers

The next question is: Why do exchange rates change in value? When looking at an exchange rate graph, you may notice it changes every day. The graph below from online database FRED, for example, shows daily changes in the Swiss franc/U.S. dollar exchange rate for three years, ending on Aug. 25, 2023, when the ratio was 0.89.

SOURCE: Online database FRED as suggested in a Sept. 11, 2023, FRED Blog post.

Like other prices, most exchange rates are set by supply and demand for currencies. For example, when demand for the Swiss franc increases, the dollar price of francs rises.

There are several reasons for such fluctuations in demand.

• Inflation rates differ between countries.
• Interest rates set by a country’s central bank differ.
• The total amount of public debt alters.
• The terms of international trade change.
• The overall economic health of a country changes.

Although these are some of the leading causes of changes in exchange rates, there is a lot of nuance. For example, as of the date of this blog post, the U.S. had the most debt in dollar terms, the largest trade deficit in the world and inflation higher than the 2% target rate. Yet, the U.S. dollar is still viewed as stable, and many countries use the dollar as a reserve currency and use their currencies’ exchange rates with the dollar in policy goals. So why is the dollar used in this way? Because the U.S. has a robust economy, strong government institutions and the good faith of investors that it will pay back its debt obligations.

As that example shows, exchange rates are complex, but this blog post is a good starting point for understanding them.

Editor’s Note: In an update, parenthetical information giving a dollar/franc ratio instead of dollars needed to purchase a Swiss franc if the dollar weakened was corrected to the dollars needed.

Note

1. The inverse of an exchange rate is also a perfectly valid exchange rate, but it is customary to quote a particular exchange rate in a particular “direction.” That is, it is customary to quote the exchange rate involving the U.S. dollar and the Swiss franc in terms of U.S. dollars per Swiss franc.