The Foreign Exchange Market
- Explain how supply and demand determine a flexible exchange rate
- Distinguish appreciation from depreciation of a currency
- Predict how changes in demand or supply shift the equilibrium exchange rate
Currencies have a price too
The foreign exchange (forex) market is where currencies are traded, and the exchange rate is simply the price of one currency in terms of another. Under a flexible (floating) exchange rate, this price is set by supply and demand for the currency. The demand for a currency comes from foreigners who want it to buy that country’s exports or assets; the supply comes from domestic residents offering their currency to buy foreign goods or assets. The two curves cross at the equilibrium exchange rate, just like any market.
Appreciation vs. depreciation
A currency appreciates when it becomes more valuable — it takes fewer units of it (or more of the foreign currency) to buy — and depreciates when it becomes less valuable. When one currency appreciates, the other necessarily depreciates: if the dollar rises against the euro, the euro falls against the dollar. An appreciation makes a country’s exports more expensive abroad and imports cheaper at home; a depreciation does the reverse, making exports cheaper and imports pricier. This link between the exchange rate and net exports is central to the open economy.
What shifts currency demand and supply
Demand for a currency rises (it appreciates) when foreigners want more of its exports, when its assets pay higher interest rates (attracting capital inflows), when it becomes a preferred safe haven, or when relative incomes and tastes favor its goods. Supply of a currency rises (it depreciates) when residents demand more foreign goods and assets — for instance, if domestic interest rates fall, capital flows out. Relative interest rates and relative price levels/incomes are the shifters the exam tests most: higher domestic interest rates → capital inflow → currency appreciates.
Interest rates in the United States rise relative to those in Europe. Using the foreign exchange market, explain the effect on the value of the U.S. dollar and on U.S. net exports.
- 1.Higher U.S. interest rates make U.S. assets (bonds) more attractive to European investors, who need dollars to buy them.
- 2.This increases the demand for dollars in the forex market, shifting dollar demand right.
- 3.The equilibrium exchange rate rises: the dollar appreciates against the euro.
- 4.A stronger dollar makes U.S. exports more expensive abroad and imports cheaper, so U.S. net exports fall.
Demand for the Japanese yen increases as foreign tourists flock to Japan and buy more Japanese goods. In the foreign exchange market for yen, this causes the yen to:
Every exchange-rate story has two currencies, and they move in opposite directions. If the dollar appreciates against the euro, the euro depreciates against the dollar. Make sure your answer names which currency and which direction for both.
The U.S. dollar appreciates significantly against its trading partners’ currencies. What is the likely effect on U.S. exports and imports?
On forex diagrams, label the axis carefully: the price is the exchange rate (foreign currency per unit of the currency shown). Shift the correct curve — demand for capital-inflow and export stories, supply for capital-outflow and import stories — and state the effect on net exports.
Answer the 2 checkpoints as you read.
Sign in to save your progress