Foreign trade involves the use of different national currencies. The relative price of two currencies is called the foreign exchange rate, which measures the price of 1 unit of domestic currency in terms of foreign currency. The foreign exchange rate is determined in the foreign exchange market, which is the market where different currencies are trade. For example, if the French franc sells at 5 francs to the U.S dollars, we say that the foreign exchange rate is 5 franc per dollar. The foreign exchange rate is an important determinant of international trade because it has a large effect on the relative prices of the goods of different countries. To see how the foreign exchange rate affects foreign trade, take wine as an example. The relative prices of U.S wine and French wine will depend upon the domestic prices of the wines and upon the foreign exchange rate. Say that California Chardonnay wines sell for $6 per bottle, while the equivalent French Chardonnay sells for 40 French francs to the dollars, French wine sells at $4 per bottle while California wine sells at $6, giving an advantage to the imported variety.
