Exchange Rates and Their

Determination: A Basic Model

Introduction
 Why is the exchange rate important?
 What causes the exchange rate to
change?
 What determines the supply and
demand for foreign exchange?
 What do economists know about the
effects of exchange-rate volatility on
international markets?
Exchange Rates
 The price of one country’s currency in
terms of another.
 Demand for foreign currency comes
from demand for foreign goods and
services.
 When US buys goods from foreign
country, we must exchange dollars for
the foreign currency.
Exchange Rates
 Demand for foreign currency relative to
supply of foreign currency determines
the exchange rate.
 Appreciation – an increase in the value
of a currency
 Depreciation – a decrease in the value
of a currency
Exchange Rates - Example
 Assume current exchange rate for the
euro is 1.5 dollars per euro
 If exchange rate rises to 2.5 dollars per
euro, the dollar has depreciated
 Price has risen, but each dollar is now
worth less relative to the euro
 More dollars required to buy a euro
Exchange Rates - Example
 If exchange rate moves to 0.5 dollars
per euro, the dollar has appreciated.
 Price has fallen, but each dollar is worth
more relative to the euro
 Fewer dollars required to buy a euro.
Exchange Rates
 Depreciation and appreciation, as
defined, are for exchange rates quoted
as domestic currency per foreign
currency – Direct quote
 Exchange rates can be quoted as units
of foreign currency per domestic
currency – Indirect quote
Exchange Rates - Reporting
 Since some currency is reported using direct
quotes and some using indirect quotes, some
confusion can occur
 Yen are quoted using indirect quotes
 Pounds are quoted using direct quotes
 Increase in direct quote rate – depreciation
 Increase in indirect quote rate - appreciation
 Spot Exchange Rates
 Spot exchange rate – Exchange rate
relevant to current foreign-exchange
transactions
 Can measure percentage appreciation
or depreciation of spot rate over time
with direct quotes
Beginning Rate  Ending Rate
%Δ in SpotRate  * 100
Beginning Rate
Exchange Rate of US Dollar
Exchange Rate of US Dollar
Demand for Foreign Exchange
 Results from domestic residents
demanding foreign goods/services
 Exchange rate is price of foreign
exchange
 Demand curve for foreign exchange is
made from how much foreign currency
is demanded at each exchange rate
Demand for Foreign Exchange
 US wants to buy German Sausages and
they cost $50 Euro per box
 Dollar price of sausages depends on
exchange rate
 At 1.5 dollars per Euro, cost to US is $75
 At 2 dollars per Euro, cost to US is $100
 At 2.5 dollars per Euro, cost to US is $125
Demand for Foreign Exchange
 As the exchange rate increases, it costs
more to buy the sausages so the
quantity demanded decreases
 Price of sausages stays the same
 The only thing changing is price –
foreign exchange rate – so we have
determined a demand curve for Euros
 Demand for Foreign Exchange
$/Euro

2.5

2.0

1.5 Demand
for Euros

100 200 300 Euros

Demand for Foreign Exchange
 At 2.5 dollars per euro, a vacation in
Italy becomes much more expensive
 Similarly, at higher exchange rates,
financial assets become more expensive
 Must be able to distinguish between
changes in demand and changes in
quantity demanded
Shifts in Demand – Foreign Exchange
 Similar to shifts in demand for other goods
 Changes in a country’s tastes/preferences
 Changes in a country’s income level
 Changes in relative price levels
 Changes in productivity levels
 Changes in the degree of trade restrictions
 Most important are income and relative
prices
Changes in Domestic Income
 US income increases
 Demand for all goods including imports
increases
 This leads to a shift in demand for
foreign currency
 Declines in income will work just the
opposite
 Increase in Domestic Income
$/Euro

2.0
New
Demand
Demand
for Euros
100 200 300 Euros
 Decrease in Domestic Income
$/Euro

2.0

Demand
New for Euros
Demand
100 200 300 Euros
 Changes in Relative Prices
 Assume prices for all goods rose in
Germany
 If exchange rate did not change, then
prices of German goods in US would
increase
 If US goods are competitive, then buyers
will substitute cheaper (US) goods for
more expensive (German) goods
Changes in Relative Prices
 The substitution decreases demand for
Euros since fewer German goods are
being purchased
 Demand for Euros would shift left with
fewer Euros demanded at every given
exchange rate.
 The opposite is true for US prices rising
relative to German prices
Changes in Relative Prices
 Price level changes are not this exact
 Most countries experience continual price
changes and have differing amounts of
inflation
 Countries with high levels of inflation relative
to trading partners will see more increase in
demand for foreign goods and foreign
exchange
 Leads to depreciation of their currency over time
Supply of Foreign Exchange
 Supply of currency in market comes as a
result of a countries demand for another
counties goods.
 France wants to buy US products
 They need US dollars to supply Euros for
dollars
 France’s demand for dollars to buy US
goods effectively creates supply of Euros
Supply of Foreign Exchange
 Example:
 France wants to buy US Wheat
 Price of wheat is $30/bushel
 At 1.5 $/Euro, France supplies 20 Euro
 At 2.0 $/Euro, France supplies 15 Euro
 At 2.5 $/Euro, France supplies 12 Euro
 At higher exchange rates, demand for wheat
is higher and quantity of Euro supplied is
higher – change in quantity supplied
Supply of Foreign Exchange
$/Euro
Supply
of Euros
2.5

2.0

1.5

100 200 300 Euros

Supply of Foreign Exchange
 As dollar depreciates, US goods are less
expensive and foreigners buy more US
goods
 Quantity supplied of foreign currency
increases
 Supply of foreign currency in foreign
exchange market depends on foreign
demand for imports
Shifts in Supply – Foreign Exchange
 Supply can shift in response to changes
in other factors.
 Two most important factors
 Changes in foreign income
 Changes in relative prices
Changes in Foreign Income
 Income for France increases
 Demand for all goods increases – including
demand for imports
 To buy more US goods, France must sell
more Euros in exchange for dollars
 Increase in the supply of foreign exchange
at any given exchange rate
 Remittances
Increase in France’s Income
$/Euro Supply
of Euros
New
2.5 Supply

2.0

1.5

100 200 300 Euros

Changes in Foreign Income
 Income for France decreases
 Demand for all goods decreases – including
demand for imports
 Buying fewer US goods, France does not
sell as many Euros in exchange for dollars
 Decrease in the supply of foreign exchange
at any given exchange rate
Decrease in France’s Income
$/Euro New
Supply
Supply
2.5 of Euros

2.0

1.5

100 200 300 Euros

Changes in Relative Prices
 Prices in Germany rise relative to prices in US
 German demand for US goods increases.
 Germans substitute relatively cheaper goods for
higher priced goods.
 Increase in demand for imports requires Germany
selling Euros for Dollars
 Rightward shift in Supply of Euros
 Opposite effect for decrease in relative prices
Equilibrium – Foreign
Exchange
 Equilibrium exchange rate occurs with
then quantity demanded of foreign
exchange equals the quantity supplied
 In our examples, the amount of Euros
US consumers want to buy equals the
amount of Euros the European country
wants to sell
Equilibrium in Euro Market
$/Euro
Supply
of Euros
2.5

2.0

1.5 Demand
for Euros

100 200 300 400 500 Euros

Equilibrium - Foreign Exchange
 Exchange rate fluctuate during a typical
trading day much more than over the long
run
 Equilibrium should be thought of as the point
that would occur if all other factors remain
constant
 Exchange rates move very quickly as
economic conditions and expectations change
Foreign Exchange Market
 Increased demand for imports in the US
will cause an increase in the demand
for foreign exchange
 US incomes could have risen
 If supply is held constant, the exchange
rate must increase to clear the market
Increase in demand
$/Euro
Supply
of Euros
2.5

2.0 New
Demand
1.5 Demand
for Euros

100 200 300 400 500 Euros

Change in Relative Prices
 Prices of goods in US rise relative to
those in France
 Demand for Euros increases as US demand
for relatively cheaper (French) goods
increases
 Supply of Euros decreases and French
decrease demand of US imports
Change in Relative Prices
New Supply
$/Euro

3.0 Supply
of Euros
2.5
2.0 New
Demand
1.5
Demand
for Euros

100 200 300 400 500 Euros

Change in Relative Prices
 New equilibrium exchange rate rose but the
volume of trade was unchanged
 Exchange rate attempts to correct for
changes in relative prices
 Countries with high/low inflation rates have
currencies that depreciate/ appreciate over
time
 Depreciation is markets way of compensating
for differing rates of inflation
Impact of Changes
Exchange Rates and International
Trade
 Changes in exchange rates make
international trade much different from
domestic interregional trade
 Changes can be partially mitigated
through use of forward or futures
markets for foreign exchange
 Reduction of risk has a cost
 Difficult to forecast in the long run
Exchange Rates and International
Trade
 Risk and uncertainty have the result of
depressing international trade and
investment
 Magnitude of effect is not known
 Creates a bias toward domestic
transactions if exchange rates are
allowed to fluctuate
Exchange Rates and International
Trade
 Fluctuating exchange rates have lead to
an industry of forecasters
 Need reasonable accurate for country’s
GDP and inflation levels
 Also other factors that affect exchange
rates not discussed here
 This model is good for general
comments about exchange over the
medium to long run
Exchange Rates and International
Trade
 Model is not set up to make accurate
predictions over shorter periods
 Useful representation of what world
producers and consumers face in
international markets