Exchange rates

There are many explanations for the variations in exchange rates - political, economic, psychological explanations.

Let's imagine that there are only economic reasons for the currencies of two countries change their relationship. It's an incomplete picture, but explains the basic operations for the process.

First, we need to know that for a country's currency has value, it must be ensured by the production of that country. After all, money is a painted piece of paper: you can't eat money, money does not dresses you. The significance of the coin, as the value accepted by many, depends on what ensures the value: human labor and the riches that are processed behind the wallpaper - a ballast is needed.

Two countries, Lilliput and Blefuscu, have their natives currencies. Suppose Blefuscu's economy has twice the strength of Lilliput's economy. Blefuscu produces twice as much grain, twice as tissues and the economically active population is twice that on Lilliput. In this ideal situation, the currency of Blefuscu ($B) is worth twice that of Lilliput's (L$). The relation is: $1B = $2L.

A Lilliput's trader manufactures and exports pens to Blefuscu. To make a pen, he spends $0,20L on plastic, $0,10L on ink, $0,50L to salary, $0,30L for overhead costs and his profit margin is $0,40L. So, the pen goes for 0,20 + 0,10 + 0,50 + 0,30 = $1,10L plus the profit of L $0,40L, we have $1,50L for the selling price of the pen. As the exchange rate is two to one ($1B = $2L), Blefuscu buys the pen for $0,75B.

But internal changes in the economy of Lilliput make the production becomes more expensive. The plastic is more expensive, workers negotiate a better salary, the price of electricity rises. So now the pen goes for $1,80L - 20% more expensive than before. The exporter of Lilliput talks to the Blefuscu's importer that the price went up. The importer says he can get pens in other country by the old price and only will pay $0,75B.

What outputs our Lilliputian exporter has? First, reduce his profit margin from $0,40L to $0,10L and keep the price at $1,50L, except that it can cripple the business. So he can do another thing: if the Blefuscu's price is $0,75B per pen and its cost is now $1,80L per pen, the relationship between the currencies can be changed: if Flimnap, the Lilliputian lord high treasurer, agrees, from now on we will equal $1,80L to $0,75B and the price for the two parts fit. The relationship goes from $1B = $2L to $1B = $2,40L. Lilliput's currency depreciated 20% against the Blefuscu's currency - the same 20% of rising costs to the production of pens.

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