Changes in the exchange rate

Shifts to Demand Curve for US Dollars

The Demand Curve can shift right or left in the graph.



How does it shift? There are 3 ways:

1. World Demand for US Exports: With the number of the exports, we see that
   1. If the demand for US exports increase, then the demand for US dollars increase. (right shift)
   2. If the demand for US exports decrease, then the demand for US dollars decrease. (left shift)


2. US Interest Rate & Foreign Interest Rate: The gap between the US interest rate and the foreign interest rate is called the US interest rate differential.
   1. If the US interest rate differential increase, then the demand for US dollars increase. (right shift)
   2. If the US interest rate differential decrease, then the demand for US dollars decrease. (left shift)


3. Expected Future Exchange Rate: Depending on the exchange rate in the future, people could either make profit holding US dollars or foreign currency, which determines the demand of US dollars.
   1. If expected future exchange rate increase, then the demand for US dollars increase. (right shift)
   2. If expected future exchange rate decrease, then the demand for US dollars decrease. (left shift)

Shifts to Supply Curve for US Dollars

The Supply Curve can shift right or left in the graph.



How does it shift? There are 3 ways:

1. World Demand for US Imports: With the number of the imports, we see that
   1. If the demand for US imports increase, then the demand for US dollars increase. (right shift)
   2. If the demand for US imports decrease, then the demand for US dollars decrease. (left shift)


2. US Interest Rate & Foreign Interest Rate: The gap between the US interest rate and the foreign interest rate is called the US interest rate differential.
   1. If the US interest rate differential decrease, then the supply for US dollars increase. (right shift)
   2. If the US interest rate differential increase, then the supply for US dollars decrease. (left shift)


3. Expected Future Exchange Rate: Depending on the exchange rate in the future, people could either make profit holding US dollars or foreign currency, which determines the demand of US dollars.
   1. If expected future exchange rate decrease, then the supply for US dollars increase. (right shift)
   2. If expected future exchange rate increase, then the supply for US dollars decrease. (left shift)

Appreciation & Depreciation of US dollars

With shifts in demand and supply, we can also see the appreciation and depreciation of US dollars.

Case 1: Suppose the Federal reserve in the US decides to raise the interest rate.

If a foreign country’s interest rate does not change, then there is an increase in the US interest rate differential. In this case, the demand for US dollars increases and the supply for US dollars decrease.

So, we get the following graph,



The result in the graph shows that the quantity of US dollars stays the same, but the exchange rate rises, causing an appreciation for US dollars.

Case 2: Suppose the Federal reserve in the US decides to decrease the interest rate.

If a foreign country’s interest rate does not change, then there is a decrease in the US interest rate differential. In this case, the demand for US dollars decreases and the supply for US dollars increase.

So, we get the following graph,



The result in the graph shows that the quantity of US dollars stay the same, but the exchange rate falls, causing a depreciation for US dollars.


Real Exchange Rate

Real Exchange Rate: measures the price of domestic goods relative to the price of foreign goods. It is calculated by using the formula

RER = $\large \frac{E \; \times \; P} {P^{*}}$
Where:
$E$ = exchange rate
$P$ = price level of domestic goods
$P^{*}$ = price level of foreign goods.

Short Run: Changes in the nominal exchange rate also changes the real exchange rate. This is due to price levels of domestic and foreign goods not changing every time the nominal exchange rate changes.

Short-run changes to the real exchange rate changes the quantity of imports demanded and exports supplied.

Long Run: Changes in the nominal exchange rate does not change the real exchange rate. This is due to price levels of domestic and foreign goods changing every time the nominal exchange rate changes.