The exchange rate

You leave for New York with one thousand euros. At the counter, say you get one thousand one hundred dollars. Why that number?

Because an exchange rate is a price. The price of one currency, paid in another.

Here, one euro is worth one dollar ten. That is the quote: how much of one currency for one unit of the other.

Seen from America, the same thing is written the other way round: one dollar is worth about zero point nine one euros.

Both ways say the same thing. But you must always know which one you are reading. Otherwise, you read everything backwards.

A year later, say one euro is worth one dollar twenty. What happened?

The euro has appreciated: it buys more dollars. A little over nine per cent more.

And the dollar has depreciated: it buys fewer euros. A little over eight per cent less.

Same movement, two different numbers. It all depends on the point of view.

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For you, in New York, it is good news. A room at two hundred and twenty dollars cost two hundred euros. Now it costs only one hundred and eighty-three.

For a European company selling in America, it is the opposite. Its products become dearer over there.

So what is the right rate? An old theory answers: purchasing power parity.

The idea: in the long run, the same basket should cost the same everywhere, once converted.

Otherwise, people buy where it is cheaper. And prices, or the exchange rate, end up adjusting.

To make it readable, The Economist newspaper has published the Big Mac index since nineteen eighty-six.

The same sandwich, sold in dozens of countries. Its price is compared, country by country.

Say it costs five euros in Europe and six dollars in the United States. The rate that matches the two: one dollar twenty per euro.

If the market says one dollar ten, the euro looks undervalued by a little over eight per cent. The sandwich is cheaper here.

But a Big Mac also contains local rents and wages, which do not travel. The index is a guide, not a forecast.

And purchasing power parity works badly in the short run. Gaps can last for years.

So, three reflexes. Read the quote the right way round. And always ask: appreciated for whom?

And remember that in the long run, prices pull currencies. Slowly, but they pull.