Example: Lessening Risk

key terms

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common currency

exchange rate

international trade

investment

No exchange rate uncertainty lessens the risk of investing and trading across borders.

Any trade between countries that do not share a common currency involves some exchange rate uncertainty. There is some chance that the exchange ratebetween the two countries will change. This change could affect profits, returns to investment, competitiveness, or a consumer’s decision.

For example, before joining the monetary union, a German pants maker is thinking of building a factory investment) in Spain. For simplicity, assume that all the pants produced in the Spanish factory are sold in Spain, so that any profit or return on that investment that is made will be in pesetas (the former Spanish currency). In order for the German firm to use this return, or profit, it must convert the pesetas into mark (the former German currency). Fluctuations in the exchange rate will cause the amount of profit that the German firm receives to fluctuate, even if the peseta amount of profit is the same each year. In its decision on whether to build this factory or not, the German firm must take into account the risk that will come with fluctuating exchange rates. At some exchange rates it would be better to use the money available for investment to build a factory in Germany; at other exchange rates it would be better to build it in Spain. The uncertainty will cause fewer German firms to invest in Spain than would have had there been no exchange rate uncertainty.

Along the same lines, exchange rate uncertainty also goes into a firm’s decision of selling its product in another country. Let’s say that the German firm takes the price of its pants in terms of the mark and converts that price into pesetas. 100 mark pants in Germany (if 100 mark = 8507 peseta) will be 8507 pesetas in Spain. If the exchange rate suddenly appreciates and 100 mark now = 9000 pesetas, then the pants will now cost the Spanish consumer 9000 pesetas – even though the price of the pants did not raise in terms of mark. The German pants maker now does not sell as many pants in Spain; it may even lose money. So before the pants maker decides to sell pants in Spain, it must decide if it can handle the risk associated with a changing exchange rate.  The uncertainty will lead fewer German firms to sell their products in Spain than would have had there been no exchange rate uncertainty. Thus adopting a common currency eliminates exchange rate uncertainty, and international trade between the two countries increases.

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