My wife traveled to Ireland with a friend after she graduated with her bachelor’s degree. She had lived in Europe as a child and had travelled for mission trips. But travelling to the Irish Republic as a young adult, for the singular purpose of celebration and leisure, made a big impact on my eventual wife and she recounted it for years.
Remember pre-Covid when life was so easy? Many of us had planned trips, for business and leisure, that were interrupted. By now, the vast majority of people are back to ‘normal’ (I think?). Classes are in-person, masks are largely optional, and there is no more line stretching out down the sidewalk near the Trader Joe’s. With all this normalcy, one might ask:
Where’s your next vacation?
One way to think about your next destination is by considering the kind of experience that you can afford. Now, think back to your previous self, way back in January and February of 2020. Where did you want to go then? Whatever your answer is, now consider how well you can afford a better vacation than you could two years ago. It depends on the destination, of course, but maybe it’s, say, 10% cheaper. If that’s the case, then you should be even more enthusiastic about that destination now than you were at the time. After all, you can afford 10% more vacation, or afford to spend 10% less on a specific experience.
One way to think about how much you can afford is to consider the different rates of inflation experienced by your potential vacation destinations. Say that you were on the fence between visiting Edinburgh and Tokyo. After all, if the price level rose by 10% in the United Kingdom since January 2020 and prices rose in Japan by 5%, then you might think that Japan is now the better option (James Bailey and Jeremy Horpedahl have compared international inflation rates recently).
The logic is solid. If relative prices change, then we will happily substitute to the option that experiences a smaller price increase. Except, when conducting trade across borders, there is another price that we haven’t considered: the price of foreign currency. After all, it may be that prices fell in a country and that the price of the currency rose. In order to say whether we can afford more or less, we need some help.
Economists use the concept of the real exchange rate in order to compare where one can afford more or less. For example, if your $20 can afford two beers in the US and three beers in the UK, then you’re better off buying in the UK. In fact, we can be more specific and say that for every one US beer that we drink, we’re foregoing the opportunity to purchase one and a half UK beers. Clearly, drinking British beer is the more affordable option. Sounds like it’s time to visit Big Ben, Manchester United, and the Crown Jewels.
Below is the equation for the real exchange rate ‘q’, the number of foreign goods you forego in order to purchase a good domestically. ‘e’ is the exchange rate expressed as the number of foreign currency units necessary to purchase a domestic unit of currency. If q is greater than 1, then you can afford more in the foreign country relative to the domestic country.
Calculating numbers from the above is OK. But what would it mean for you, personally? Back in early 2020, you had desires to travel. How do those plans fit into the above equation? Good question. Using some mathematical magic, we can convert the real exchange rate to percent change.
Where π is the domestic or foreign rate of inflation, and ε is the percent change in the exchange rate. The equation yields how much more we can afford in percentage terms. The bigger that number, the more you can afford to travel abroad than you could previously (relative to a staycation).
Personally, I had desires to visit Spain, Italy, or the UK. But, for variety, I’ll also illustrate the numbers for Japan and Mexico. Below is the percent change in purchasing power from January of 2020. Contrary to doom and gloom concerning the value of the US dollar, now is *GREAT* time to travel – for Americans. Our incomes can now afford much more in all of the countries below than they could at the start of the pandemic. Have you been brushing up on your Duolingo Spanish? Because now you get a nice 8% discount on Mexican goods relative to domestic. In Japan, the deal is even better. US dollars can afford 20% more in Japan than they can in the US relative to two years ago (Sake for everyone!). The deals in Europe aren’t great, but a few percent more affordable is still more affordable.
Importantly, I am not talking about the strength of the US dollar, which has lost domestic purchasing power due to inflation. I’m talking about the choice to purchase goods domestically. It’s not that we can afford 8% more in Mexico with our dollars. It’s that we can afford 8% more in Mexico if we forego a domestic US purchase.
If you were on the fence between Mexico and Spain previously, now you know that the affordability advantage of Mexico over Spain is even bigger. Or maybe you really preferred traveling to Italy prior to the pandemic. But, with Japanese goods now 15% more affordable than Italian goods compared to two years ago, you’d have to get about 15% more pleasure from traveling to Italy instead.
In conclusion, you get what you pay for. And US dollars spent overseas can now pay for a lot. Wherever you were thinking about traveling in early 2020, let yourself be influenced by the change in relative prices. Go lie on a beach or lounge in a café somewhere and enjoy the international strength of the US dollar.