How Exchange Rates Are Determined: A Supply-and-Demand Analysis

Use a supply-and- demand framework to explain how exchange rates are determined.

In flexible-exchange-rate systems, exchange rates change constantly. In fixed- exchange-rate systems, by definition, exchange rates are stable most of the time; even under a fixed-rate system, large devaluations or revaluations aren't uncom­mon.

For clarity, our supply-and-demand analysis focuses on the nominal exchange rate rather than the real exchange rate. However, recall from Eq. (13.1) that, for given levels of domestic and foreign prices, the real exchange rate and the nominal exchange rate are proportional. Because we hold price levels constant in this section, all our conclusions about the nominal exchange rate apply equally to the real exchange rate.

The nominal exchange rate, e _nom, is the value of a currency—say, the dollar. The value of the dollar, like that of any asset, is determined by supply and demand in the relevant market. For dollars, the relevant market is the foreign exchange market, where banks and currency traders continuously trade dollars for other currencies.

Figure 13.3 shows the supply and demand for dollars. The horizontal axis measures the quantity of dollars supplied or demanded, and the vertical axis mea­sures the value of the dollar in terms of other currencies, or the nominal exchange rate, e_nom. The supply curve for dollars, S, shows the number of dollars that people want to supply to the foreign exchange market at each "price" (nominal exchange rate). To supply dollars to the foreign exchange market means to offer to exchange dollars for some other currency.

Figure 13.3 helps explain the forces that determine the value of the dollar, or any other currency. To go any further, though, we must ask why people decide to demand or supply dollars. Unlike apples or haircuts, dollars aren't demanded

FIGUREJ3.3

The supply of and demand for the dollar The figure shows the determination of the value of the dollar in the foreign exchange market. The supply curve for dol­lars, S, indicates the number of dollars that people are willing to sell in the foreign exchange market at each value of the U.S. nominal exchange rate, e _nom.

The demand curve for dollars, D, shows the number of dollars that people want to buy at each nominal exchange rate. At equilibrium, point E, the value of the dollar, e n_om, is the nominal exchange rate at which the quantity of dollars supplied equals the quan­tity of dollars demanded.

because people value them in themselves; rather, people value dollars because of what they can buy. Specifically, foreign individuals or firms demand dollars in the foreign exchange market for two reasons:

1. to be able to buy U.S. goods and services (U.S. exports), and

2. to be able to buy U.S. real and financial assets (U.S. financial inflows).

Note that the two types of transactions for which foreigners need dollars (to purchase U.S.

Similarly, U.S. residents supply dollars to the foreign exchange market, thereby acquiring foreign currencies, for two reasons:

1. to be able to buy foreign goods and services (U.S. imports), and

2. to be able to buy real and financial assets in foreign countries (U.S. financial outflows).

FIGUREJ3.4

The effect of increased export quality on the value of the dollar

An increase in the qual­ity of U.S. exports raises foreigners' demands for U.S. goods and hence their demand for U.S. dollars, which are needed to buy U.S. goods. The demand curve for dollars shifts from D¹ to D², and the supply curve of dollars shifts from S¹ to S², raising the value of the dollar (the nominal exchange rate) from e n_om to e^{2 uo e} nom.

Thus factors that increase foreigners' demand for U.S. exports and assets will also increase the foreign-exchange-market demand for dollars, raising the dollar exchange rate. Likewise, the value of the dollar will rise if U.S. residents' demand for foreign goods and assets declines, so they supply fewer dollars to the foreign exchange market.

For example, suppose that U.S. goods improve in quality so that foreigners demand more of them. This increase in the demand for U.S. exports would trans­late into an increase in the demand for U.S. dollars. In Figure 13.4 the demand curve for dollars shifts to the right, from D¹ to D². An improvement in the quality of U.S. goods may also lead U.S. residents to substitute U.S. goods for foreign goods, thereby reducing U.S. imports, and reducing the supply of dollars in the foreign exchange market at each real exchange rate, shifting the supply curve of dollars from S¹ to S².

Macroeconomic Determinants of the Exchange Rate and Net Export Demand

In our previous IS-LM analyses we emphasized two key macroeconomic vari­ables: real output (income), Y, and the real interest rate, r. In anticipation of the open-economy version of the IS-LM model presented in Section 13.3, we now consider how changes in real output or the real interest rate (either at home or abroad) are linked to the exchange rate and net exports. Again, because we are holding domestic and foreign price levels constant, the results we discuss here apply equally to the nominal exchange rate and the real exchange rate.

Effects of Changes in Output (Income). Imagine that domestic output (equiv­alently, domestic income), Y, increases but that other factors (such as the real interest rate) remain unchanged. How would the increase in Y affect the exchange rate and net exports?

To consider the effect on net exports first is easier. We know that spending by consumers depends in part on their current incomes. When domestic income rises, consumers will spend more on all goods and services, including imports. Thus when domestic output (income) rises, net exports (exports minus imports) must fall, other factors held constant.^[241]

To determine the effect of increased domestic output on the exchange rate, recall that, to increase their purchases of imports, domestic residents must obtain foreign currencies. Equivalently, domestic residents must supply more domestic currency to the foreign exchange market. An increased supply of domestic cur­rency causes its value to fall; that is, the exchange rate depreciates.

We can also analyze the effects of an increase in the real output of the coun­try's trading partners, Y_For (foreign output or income).

Effects of Changes in Real Interest Rates. A second key macroeconomic variable to be considered is the real interest rate. Imagine that the domestic coun­try's real interest rate, r, rises, with other factors (including the foreign real interest rate) held constant.^[242] In this case, the country's real and financial assets will become more attractive to both domestic and foreign savers seeking the highest return on their funds. Because domestic currency can be used to buy domestic assets, a rise in the domestic real interest rate also increases the demand for and reduces the supply of domestic currency. An increased demand and decreased supply of domestic currency in turn leads to exchange rate appreciation.

A rise in the domestic real interest rate, r, has no direct effect on net exports, but it does have an indirect effect through the exchange rate. An increase in r raises the exchange rate so that domestic exports become more expensive and imports from abroad become cheaper. Thus other factors being constant, an increase in r reduces the domestic country's net exports.

The effects of a change in the foreign real interest rate, r_For, are the opposite of the effects of a change in the domestic real interest rate. If the foreign real interest rate rises, for example, foreign assets will become more attractive to domestic and foreign savers. To get the foreign currency needed to buy foreign assets, domestic savers will supply domestic currency to the foreign exchange market.

Summary tables 16 and 17 list the effects of the various macroeconomic fac­tors on the exchange rate and net exports.

13.3