Application Yen Appreciation Harms Japanese TV Producers 
For most of 1985, the yen traded at about ¥240 = $1. By 1995, the yen’s value had risen to about ¥90 = $1, without a commensurate increase in U.S. inflation. This rise had a highly negative impact on Japanese television manufacturers. If it cost, say, ¥100,000 to build a color TV in Japan, ship it to the United States, and earn a normal profit, that TV could be sold in 1985 for about $417 (100,000/240). However, in 1995, the price would have had to be about $1,111 (100,000/90) for Japanese firms to break even, presenting them with the following dilemma: Because other U.S. prices had not risen much, as Japanese firms raised their dollar price to compensate for yen appreciation, Americans would buy fewer Japanese color TVs, and yen revenues would fall. If Japanese TV producers decided to keep their price constant at $417 to preserve market share in the United States, they would have to cut their yen price to about ¥37,530 (417 × 90). In general, whether they held the line on yen prices or cut them, real yen appreciation was bad news for Japanese TV manufacturers. Subsequent yen depreciation eased the pressure on Japanese companies.
Alternatively, Industrias Penoles, the Mexican firm that is the world’s largest refiner of newly mined silver, increased its dollar profits by more than 200% after the real devaluation of the Mexican peso relative to the dollar in 1982. Similarly, when the peso plunged in 1995, the company saw its profits rise again. The reason for the firm’s success is that its costs, which are in pesos, declined in dollar terms, and the dollar value of its revenues, which are derived from exports, held steady.
In summary, the economic impact of a currency change on a firm depends on whether the exchange rate change is fully offset by the difference in inflation rates or whether (because of price controls, a shift in monetary policy, or some other reason) the real exchange rate and, hence, relative prices change. It is these relative price changes that ultimately determine a firm’s long-run exposure.
A less obvious point is that a firm may face more exchange risk if nominal exchange rates do not change. Consider, for example, a Brazilian shoe manufacturer producing for export to the United States and Europe. If the Brazilian real’s exchange rate remains fixed in the face of Brazil’s typically high rate of inflation, then both the real’s real exchange rate and the manufacturer’s dollar costs of production will rise. Therefore, unless the real devalues, the Brazilian exporter will be placed at a competitive disadvantage vis-å-vis producers located in countries with less rapidly rising costs, such as Taiwan and South Korea.
Suppose, for example, that the Brazilian firm sells its shoes in the U.S. market for $10. Its profit margin is $6, or R300, because the shoes cost $4 to produce at the current exchange rate of R1 = $0.02. If Brazilian inflation is 100% but the nominal exchange rate remains constant, it will cost the manufacturer $8 to produce these same shoes by the end of the year. Assuming no U.S. inflation, the firm’s profit margin will drop to $2. The basic problem is the 100% real appreciation of the real (0.02 × 2/1). This situation is shown in Exhibit 11.3 as scenario 1.