Every year, moving goods and services around the globe becomes easier. By 2004, the volume of international transactions had grown to one-quarter of world GDP, or about $9 trillion. Today, Americans buy shoes made in China, computers assembled in Singapore, and fruit grown in Chile. But global business deals aren't limited to goods and services. Individuals, companies, and governments also invest abroad, buying and selling stocks and bonds in financial markets around the globe. The magnitude of the international flow of goods, services, and assets is impossible to ignore. To understand the nature of these transactions, we must become familiar with a key tool that makes this trade possible: exchange rates.

Whenever you buy something that has been made overseas, whether it is an article of clothing, a car, a stock, or a bond, someone somewhere has exchanged dollars for the currency used where the item was made. The reason is simple: You want to use dollars to pay for an imported shirt that you buy in a local store, but the Malaysian producer wants to be paid in ringgit. All cross-border transactions are like this; the buyer and seller both want to use their own currency. The exchange rate, at its most basic level, is the tool we use to measure the price of one currency in terms of another.

Exchange rates have broad implications both for countries and for individuals. Take the case of South Korea in the winter of 1998. As economic and financial turmoil spread through Asia starting in the summer of 1997, output and employment plunged. In Korea, large industrial companies and financial institutions approached bankruptcy. From October 1997 to January 1998, the number of South Korean won needed to purchase one dollar more than doubled, rising from 900 to 1,900 (see Figure 10.1 (44.0K) ). The consequences were dramatic, both inside and outside the country. When the cost of buying won plummeted, South Korean products became much cheaper for foreigners to buy. As the value of the won dropped, the U.S. prices of Hyundai cars and Samsung televisions fell with it. At the same time, U.S.-made products became extremely expensive for South Koreans to buy. In fact, the crisis became so severe that many Korean students at U.S. colleges and universities had to go home. The price of a U.S. education, measured in won, had doubled, and many Korean students just couldn't afford to continue.

Exchange rates go through long swings as well as sudden spikes. In 1973, the currency used in the United Kingdom, the British pound or "pound sterling," was worth $2.50. Over the next 30 years, the value of the pound declined gradually until by mid- 2004 it was worth only $1.85—a fall of 26 percent (see Figure 10.2 (44.0K) ). Nevertheless, Americans visiting Great Britain during the summer of 2004 did not return thinking that their vacations had been inexpensive. At an exchange rate of $1.85, a low-priced hotel room in London cost about the same as a fairly expensive room in New York, and even a trip to McDonald's was 16 percent more expensive than in the United States.

How are foreign exchange rates determined, and what accounts for their fluctuation over days, months, years, and decades? This chapter provides an introduction to foreign exchange rates and exchange markets.