Exchange rates
1
Foreign exchange market
As usual there are two interacting forces: the demand for our currency and the supply of our currency. The exchange rate of our currency is how much foreign currency one unit of our currency can buy. So it is the price of our currency in terms of other currencies (e.g. 1 dollar = 0.65 Euros).
2
Foreign exchange market
So the demand for our currency (e.g. dollars) gives us a picture of the amount of dollars that we want to buy for each level of exchange rate. As the exchange rate of the dollar goes down, the dollar becomes cheaper, so I want to buy more of it. The supply of dollars tells us the amount of dollars that we want to sell for each level of the exchange rate. As the exchange rate goes up, the dollar becomes more expensive, so I want to sell it.
3
A picture of the foreign exchange market
e S
e*
D
Q*
Q$
4
What happens if foreign demand for our goods (exports) increases (X↑)?
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e2 e1
The foreigners want to buy more of our goods, so they need to buy more dollars in order to pay the local producers. The demand for dollars moves to the right. The exchange rate of the dollar rises.
D2
D1
Q$
5
What happens if foreign demand for our goods (exports) decreases (X↓)?
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e1 e2
The foreigners want to buy less of our goods, so they need to buy less dollars. The demand for dollars moves to the left. The exchange rate of the dollar falls.
D2
D1
Q$
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What happens if our demand for foreign goods (imports) increases (M↑)?
e S1 S2
e1 e2
We want to buy more foreign goods, so we need to sell our dollars to get foreign currency in order to pay the foreign producers. The supply of dollars moves to the right. The exchange rate of the dollar falls.
D
Q$
7
What happens if our demand for foreign goods (imports) decreases (M↓)?
e S2 S1
e2 e1
We don’t buy as many foreign goods, so we don’t need to sell our dollars to get foreign currency. The supply of dollars moves to the left. The exchange rate of the dollar rises.
D
Q$
8
What happens if US interest rates rise?
e S2
e2
S1
e1
D1
D2
We want to invest our money in the US, so we will not want to sell our dollars. We hold on to them. The supply of dollars moves to the left. The foreigners on the other hand, for the same reason, will want to buy more dollars. The demand for dollars moves to the right. The exchange rate of the dollar rises. NCF↑ => NX↓.
Q$
9
What happens if the US interest rates fall?
e S1
e1
S2
e2
D2
D1
We don’t want to invest our money in the US because now we will get less interest, so we sell our dollars to buy other currencies. The supply of dollars moves to the right. The foreigners on the other hand, for the same reason, don’t want to buy dollars. The demand for dollars moves to the left. The exchange rate of the dollar falls. NCF↓ => NX↑.
Q$
10
What happens if foreign interest rates rise (e.g. the ECB raises its interests rates)?
e S1
e1
S2
e2
D2
D1
We want to invest our money in Europe because we will get more interest, so we sell our dollars to buy Euros. The supply of dollars moves to the right. The foreigners on the other hand, for the same reason, don’t want to buy dollars. The demand for dollars moves to the left. The exchange rate of the dollar falls. NCF↓ => NX↑.
Q$
11
What happens if foreign interest rates fall (e.g. the ECB decreases its interests rates)?
e S2
e2
S1
e1
D1
D2
We don’t want to invest our money in Europe any more, so we will not want sell our dollars. We hold on to them. The supply of dollars moves to the left. The foreigners on the other hand, for the same reason, will want to buy more dollars. The demand for dollars moves to the right. The exchange rate of the dollar rises. NCF↑ => NX↓.
Q$
12