Question

Using a suitable example, explain how currency as the unit-of-account can lead to undesirable costs.

Answer 1

When the general price level rises, each unit of currency buys fewer goods and services.

For example, assume you are a U.S. exporter who sells widgets at $\$10$ each to a buyer in Europe. The exchange rate is $\ €1=\$1.25.$ Therefore, the cost to your European buyer is €8 per widget.

Now let's say the dollar weakens and the exchange rate is $\ €1=\$1.35$ . Your buyer wants to negotiate a better price, and you can afford to give them a break while still clearing at least $\$10$ per widget. Even if you set the new price at $€7.50$ per widget, which is a $6.25\%$ discount from your buyer's perspective, your price in dollars is $\$10.13$ at the current exchange rate