Changes in the exchange rate
Intros
Lessons
- Shifts to Demand Curve for US Dollars
- 3 Ways It can Shift
- World Demand for US Exports
- US Interest Rate Differential
- Expected Future Exchange Rate
- Shifts to Supply Curve for US Dollars
- 3 Ways it can Shift
- World Demand for US Imports
- US Interest Rate Differential
- Expected Future Exchange Rate
- Appreciation & Depreciation of US dollars
- Case 1: Increase in Interest Rate
- Increase in Exchange Rate → Appreciation
- Case 2: Decrease in Interest Rate
- Decrease in Exchange Rate → Depreciation
- Real Exchange Rate
- Real Exchange Rate Formula
- Short Run
- Long Run
Topic Notes
Introduction to Exchange Rates
Welcome to our exploration of exchange rates, a crucial concept in international economics! Exchange rates represent the value of one currency in terms of another, playing a vital role in global trade and finance. They affect everything from the price of imported goods to the competitiveness of a country's exports. Our introduction video provides an excellent starting point for understanding this complex topic. It breaks down the basics of exchange rates, explaining how they're determined and why they fluctuate. As your math tutor, I'm excited to guide you through this fundamental aspect of global economics. The video will help you visualize the concept, making it easier to grasp the mathematical relationships involved. By the end of this section, you'll have a solid foundation in exchange rates, setting you up for success in more advanced economic calculations. Let's dive in and unravel the fascinating world of international currency exchange!
Understanding Demand and Supply in Exchange Rates
Exchange rates, the prices at which currencies are traded, are fundamentally determined by the interplay of demand and supply curves for different currencies. These curves represent the willingness of market participants to buy or sell a particular currency at various price levels. Understanding how these curves work and what factors influence them is crucial for anyone involved in international trade, finance, or simply interested in the global economy.
The Basics of Demand and Supply in Currency Markets
In the foreign exchange market, the demand curve for a currency (let's use U.S. dollars as an example) shows how many dollars people are willing to buy at different exchange rates. As the price of dollars in terms of foreign currency decreases, more people are willing to buy dollars, causing the demand curve to slope downward. Conversely, the supply curve for dollars represents how many dollars people are willing to sell at different exchange rates. As the price of dollars increases, more people are willing to sell, resulting in an upward-sloping supply curve.
Factors Shifting the Demand Curve
Several factors can cause the demand curve for a currency to shift:
- World Demand for Exports: If there's an increase in global demand for U.S. products, foreign buyers will need more dollars to purchase these goods, shifting the demand curve for dollars to the right.
- Interest Rates: Higher interest rates in the U.S. make dollar-denominated assets more attractive, increasing demand for dollars and shifting the curve rightward.
- Expected Future Exchange Rates: If people expect the dollar to appreciate in the future, they may buy more dollars now, shifting the demand curve to the right.
Factors Shifting the Supply Curve
Similarly, various factors can shift the supply curve for a currency:
- Imports: An increase in U.S. imports means more dollars are being supplied to buy foreign goods, shifting the supply curve to the right.
- Foreign Investment: If foreigners increase their investments in the U.S., they'll supply more of their currency to buy dollars, shifting the supply curve to the left.
- Inflation: Higher inflation in the U.S. relative to other countries can lead to an increase in the supply of dollars as people seek to exchange them for more stable currencies.
Examples in Action
Let's consider a practical example. Suppose the Federal Reserve raises interest rates in the U.S. This action would likely increase the demand for U.S. dollars as foreign investors seek higher returns. The demand curve for dollars would shift to the right, leading to an appreciation of the dollar against other currencies. Conversely, if the U.S. experiences a significant increase in imports, perhaps due to a strong domestic economy, the supply of dollars in the foreign exchange market would increase. This would shift the supply curve to the right, potentially leading to a depreciation of the dollar.
The Interplay of Multiple Factors
It's important to note that in reality, multiple factors often affect demand and supply simultaneously. For instance, while higher interest rates might increase demand for a currency, concerns about future economic stability could simultaneously decrease demand. The actual exchange rate is determined by the net effect of all these factors.
Long-term vs. Short-term Effects
Some factors have more immediate impacts on exchange rates, while others play out over longer periods. For example, changes in interest rates often have quick effects on currency markets, while shifts in export competitiveness might influence exchange rates more gradually over time.
Conclusion
Understanding how demand and supply curves affect exchange rates is essential for navigating the complex world of international finance and trade. By recognizing the factors that can shift these curves, individuals and businesses can better anticipate potential changes in currency values and make more informed decisions. Whether you're planning a vacation abroad, managing an international business, or investing in foreign markets, keeping an eye on these fundamental economic forces can help you stay ahea
Appreciation and Depreciation of Currency
Hey there! Let's dive into the fascinating world of currency appreciation and depreciation. Imagine you're at a currency exchange booth at the airport. One day, you might get more foreign currency for your U.S. dollars than you did last week. That's appreciation! On the flip side, if you get less foreign currency for your dollars, that's depreciation. Cool, right?
Now, let's break it down further:
Currency Appreciation
When a currency appreciates, it becomes more valuable relative to other currencies. This means you can buy more foreign goods and services with the same amount of your currency. For example, if the U.S. dollar appreciates against the euro, you'll get more euros for your dollars when you travel to Europe.
Currency Depreciation
Depreciation is the opposite. When a currency depreciates, it loses value compared to other currencies. You'll need more of your currency to buy the same amount of foreign goods and services. If the U.S. dollar depreciates against the euro, you'll get fewer euros for your dollars on your European vacation.
The Federal Reserve and Interest Rates
Now, let's talk about how the Federal Reserve (Fed) can influence these currency movements through interest rates. It's like a domino effect!
1. The Fed raises interest rates: When the Fed increases interest rates, it makes U.S. dollars more attractive to investors. Why? Because they can earn more interest on their dollar-denominated assets.
2. Increased demand for U.S. dollars: As more investors want to buy U.S. dollars to take advantage of higher interest rates, the demand for dollars increases.
3. Supply and demand in action: With higher demand and a relatively stable supply, the value of the U.S. dollar appreciates against other currencies.
4. Exchange rate impact: As a result, you'll need fewer U.S. dollars to buy foreign currencies, making imports cheaper but exports more expensive for other countries.
Visualizing the Change
Let's imagine a graph with the price of U.S. dollars on the vertical axis and the quantity of U.S. dollars on the horizontal axis. When the Fed raises interest rates:
- The demand curve for U.S. dollars shifts to the right (increased demand).
- The supply curve remains relatively stable.
- The intersection of these curves moves up and to the right, indicating a higher exchange rate (appreciation).
Conversely, if the Fed lowers interest rates:
- The demand curve for U.S. dollars shifts to the left (decreased demand).
- The supply curve stays the same.
- The intersection moves down and to the left, showing a lower exchange rate (depreciation).
Real-World Implications
These currency movements have significant impacts on the economy:
1. Trade: When the U.S. dollar appreciates, imports become cheaper for Americans, but U.S. exports become more expensive for foreign buyers. This can affect the trade balance.
2. Tourism: A stronger dollar means your money goes further when traveling abroad, but it might discourage foreign tourists from visiting the U.S.
3. International investments: Currency appreciation can make foreign investments less attractive, as they'll be worth less when converted back to U.S. dollars.
Conclusion
Understanding currency appreciation and depreciation is crucial in our interconnected global economy. The Federal Reserve's interest rate decisions can set off a chain reaction, influencing exchange rates and, consequently, various aspects of economic activity. By grasping these concepts, you're better equipped to navigate the complex world of
Real Exchange Rates
When discussing international trade and currency values, it's crucial to understand the concept of real exchange rates and how they differ from nominal exchange rates. Let's dive into this important economic concept and explore its implications for global trade and purchasing power.
Nominal exchange rates are the rates you typically see at currency exchange kiosks or in financial news. They represent the straightforward price of one currency in terms of another. For example, if 1 US dollar can be exchanged for 0.85 euros, the nominal exchange rate is 1 USD = 0.85 EUR. However, nominal exchange rates don't tell the whole story when it comes to the true purchasing power of currencies across different countries.
This is where real exchange rates come into play. Real exchange rates take into account not just the nominal exchange rate, but also the relative price levels in different countries. They provide a more accurate picture of the purchasing power of one currency relative to another by considering the cost of goods and services in both countries.
The formula for calculating the real exchange rate is:
Real Exchange Rate = Nominal Exchange Rate × (Foreign Price Level / Domestic Price Level)
Let's break this down with an example. Suppose we want to calculate the real exchange rate between the US dollar and the euro:
- Nominal exchange rate: 1 USD = 0.85 EUR
- Price of a basket of goods in the US: $100
- Price of the same basket of goods in the Eurozone: 90
Using our formula:
Real Exchange Rate = 0.85 × (90 / 100) = 0.765
This means that in real terms, 1 US dollar is equivalent to 0.765 euros when considering the purchasing power in both economies.
Understanding real exchange rates is crucial because they directly affect the purchasing power of currencies across countries. When the real exchange rate is higher than the nominal rate, it indicates that the domestic currency has more purchasing power abroad than the nominal rate suggests. Conversely, when the real exchange rate is lower, it means the domestic currency has less purchasing power internationally than the nominal rate implies.
Real exchange rates have significant implications for international trade and competitiveness. When a country's real exchange rate appreciates (increases), its goods become relatively more expensive for foreign buyers, potentially reducing exports. On the other hand, a depreciation (decrease) in the real exchange rate makes a country's goods more attractive to foreign buyers, potentially boosting exports.
For consumers and travelers, real exchange rates provide a more accurate picture of how far their money will go in different countries. It helps explain why some countries might seem "expensive" or "cheap" to visit, even when the nominal exchange rate doesn't suggest a significant difference.
Policymakers and economists closely monitor real exchange rates as they can indicate changes in a country's competitiveness and economic health. Persistent deviations from what's considered the "equilibrium" real exchange rate can signal underlying economic imbalances that may require policy interventions.
It's important to note that real exchange rates can change even if nominal rates remain stable. This happens when there are differences in inflation rates between countries. For example, if inflation is higher in the domestic country than in the foreign country, the real exchange rate will depreciate over time, even if the nominal rate stays the same.
In conclusion, while nominal exchange rates provide a quick snapshot of currency values, real exchange rates offer a more comprehensive view of the relative purchasing power of currencies. By accounting for price levels in different countries, real exchange rates help us understand the true cost of goods and services across borders, influencing everything from international trade to travel budgets. As you delve deeper into economics and global finance, keeping the concept of real exchange rates in mind will provide valuable insights into the complex world of international economics.
Short-run vs. Long-run Effects on Exchange Rates
Hey there, economics enthusiast! Let's dive into the fascinating world of exchange rates and explore how changes in nominal exchange rates affect real exchange rates in both the short run and long run. It's like comparing a sprint to a marathon the effects can be quite different!
First, let's clarify what we mean by nominal and real exchange rates. The nominal exchange rate is simply the rate at which you can exchange one currency for another. For example, if 1 US dollar buys 0.85 euros, that's the nominal exchange rate. On the other hand, the real exchange rate takes into account the purchasing power of currencies by considering price levels in different countries.
Now, let's look at the short-run effects. When there's a change in the nominal exchange rate, it immediately impacts the real exchange rate. Imagine the US dollar suddenly strengthens against the euro, going from 1 USD = 0.85 EUR to 1 USD = 0.95 EUR. In the short run, this change directly affects the real exchange rate because prices of goods and services don't adjust instantly.
For instance, if a cup of coffee costs 2 euros in Paris, it would have cost about 2.35 USD before the change. After the dollar strengthens, that same coffee would cost only about 2.10 USD. This makes US goods relatively more expensive for Europeans and European goods cheaper for Americans. As a result, US exports might decrease while imports from Europe could increase.
But here's where it gets interesting the long-run effects can be quite different! Over time, prices in both countries tend to adjust. This is where the concept of purchasing power parity (PPP) comes into play. According to PPP, exchange rates should eventually adjust so that the same basket of goods costs roughly the same amount in different countries when converted to a common currency.
Let's continue with our coffee example. If the stronger dollar persists, European coffee shops might start raising their prices to compensate for the exchange rate change. Similarly, US businesses might lower their prices to stay competitive. These price adjustments in response to exchange rate changes gradually offset the initial impact of the nominal exchange rate change on the real exchange rate.
So, why do these effects differ? It all comes down to the flexibility of prices and wages. In the short run, many prices are "sticky" they don't change quickly in response to economic shocks. This is why nominal exchange rate changes have an immediate impact on real exchange rates. But in the long run, prices become more flexible, allowing for adjustments that bring the real exchange rate closer to its equilibrium level.
The economic implications of these differences are significant. In the short run, changes in nominal exchange rates can have a substantial impact on a country's trade balance, competitiveness, and overall economic performance. A stronger currency might hurt exporters and benefit importers, while a weaker currency could do the opposite.
However, in the long run, these effects tend to diminish as prices adjust. This is why policymakers often focus on other factors that influence long-term economic growth and competitiveness, such as productivity, innovation, and structural reforms, rather than relying solely on exchange rate manipulation.
Let's look at a real-world example to illustrate these concepts. In 2015, the Swiss National Bank unexpectedly removed its cap on the Swiss franc's value against the euro. This led to an immediate and sharp appreciation of the franc. In the short run, Swiss exports became more expensive, and there were concerns about the impact on the country's export-oriented economy.
However, over time, Swiss companies adapted by reducing costs, improving efficiency, and in some cases, relocating production. Prices in Switzerland also adjusted gradually. While the initial shock was significant, the long-run impact on Switzerland's competitiveness was less severe than initially feared, demonstrating how economies can adapt to exchange rate changes over time.
Understanding these differences between short-run and long-run effects is crucial for policymakers, businesses, and investors. It helps explain why exchange rate fluctuations can cause immediate economic disruptions but may have less lasting impact over time. It also highlights the importance of considering both immediate and long-term consequences when making decisions related to currency markets or international trade.
In conclusion, while changes in nominal exchange rates have a direct and immediate impact on price adjustments in response to exchange rate changes, the long-term effects are moderated by the flexibility of prices and wages. This understanding is essential for making informed economic decisions.
Practical Applications of Exchange Rate Knowledge
Understanding exchange rates is not just a theoretical concept it has numerous real-world applications that can significantly impact businesses, individuals, and the global economy. Let's explore how this knowledge can be applied in various scenarios and how you, as a student, can benefit from it in your daily life and future career.
One of the most prominent areas where exchange rates play a crucial role is international trade. Companies engaged in importing or exporting goods and services must constantly monitor currency fluctuations to make informed decisions. For instance, a U.S. company exporting products to Europe will benefit when the euro is strong against the dollar, as their goods become more affordable for European buyers. Conversely, if the dollar strengthens, the company might need to adjust its pricing strategy to remain competitive in the European market.
Foreign investment is another field heavily influenced by exchange rates. Investors looking to diversify their portfolios often consider international markets. By understanding currency trends, they can make more informed decisions about where to invest their money. For example, if an investor believes that the Japanese yen will appreciate against the U.S. dollar, they might choose to invest in Japanese stocks or bonds to potentially benefit from both the asset's performance and the currency gain.
For travelers, being savvy about exchange rates can lead to significant savings. Before embarking on an international trip, it's wise to research the current exchange rates and historical trends. This knowledge can help you decide when to exchange your money for the best value. For instance, if you're planning a trip to the UK and notice that the pound is particularly weak against your home currency, it might be an opportune time to book your travel and accommodation, as your money will go further.
Businesses engaged in international operations must also consider exchange rates when making strategic decisions. A company considering opening a new factory abroad will need to factor in currency stability and exchange rate forecasts. If a country's currency is expected to depreciate significantly, it might affect the long-term profitability of the investment. Similarly, multinational corporations often use currency hedging strategies to protect themselves against exchange rate fluctuations that could impact their bottom line.
As a student, you might wonder how this knowledge applies to your daily life. Even if you're not directly involved in international business, understanding exchange rates can be beneficial in several ways. If you're considering studying abroad, keeping an eye on exchange rates can help you budget more effectively and potentially save money on tuition and living expenses. Additionally, if you shop online from international retailers, being aware of currency fluctuations can help you spot good deals and save money on purchases.
Looking towards your future career, regardless of your chosen field, having a solid grasp of exchange rates can be a valuable asset. In an increasingly globalized world, many jobs involve some level of international interaction. Whether you're in marketing, finance, supply chain management, or even healthcare, understanding how currency fluctuations can impact your industry will give you an edge in the job market.
Here are some practical tips for applying exchange rate knowledge in your daily life:
- Use currency conversion apps to stay updated on current rates
- Follow financial news to understand factors influencing exchange rates
- Practice converting currencies mentally to improve your quick estimation skills
- Consider opening a multi-currency bank account if you frequently deal with different currencies
- When traveling, compare exchange rates offered by banks, ATMs, and currency exchange offices to get the best deal
Remember, the world of exchange rates is dynamic and constantly changing. By staying informed and developing a habit of considering currency implications in various scenarios, you'll be well-prepared for a future in our interconnected global economy. Whether you're planning a vacation, considering an international internship, or dreaming of a career in global business, your understanding of exchange rates will serve you well. Embrace this knowledge as a powerful tool that can open up a world of opportunities and help you make smarter financial decisions throughout your life.
Conclusion
In this article, we've explored the crucial concept of exchange rates, a fundamental aspect of international finance. The introductory video provided a solid foundation for understanding these complex ideas. Key points covered include the definition of exchange rates, factors influencing their fluctuations, and their impact on global trade and economies. We've also discussed different exchange rate systems and their implications. To truly grasp these concepts, it's essential to apply your knowledge through practical exercises. We encourage you to further explore this topic by researching current exchange rates, practicing calculations, and analyzing real-world economic scenarios. Remember, understanding exchange rates is vital for anyone involved in international business or finance. Take the next step in your learning journey by engaging with additional resources, participating in online forums, or even tracking exchange rates over time. By doing so, you'll develop a deeper appreciation for the dynamic world of international finance and its far-reaching effects on the global economy.
Shifts to Demand Curve for US Dollars
Shifts to Demand Curve for US Dollars
- 3 Ways It can Shift
- World Demand for US Exports
- US Interest Rate Differential
- Expected Future Exchange Rate
Step 1: Understanding the Demand Curve for US Dollars
The demand curve for US dollars represents the quantity of US dollars that foreign entities want to purchase at various exchange rates. This curve can shift either to the right or to the left. A shift to the right indicates an increase in demand, while a shift to the left indicates a decrease in demand. Understanding the factors that cause these shifts is crucial for analyzing changes in the exchange rate.
Step 2: World Demand for US Exports
The first factor that can cause the demand curve for US dollars to shift is the world demand for US exports. When the demand for US exports increases, foreign buyers need more US dollars to purchase these goods and services. This increased demand for US dollars shifts the demand curve to the right. Conversely, if the demand for US exports decreases, foreign buyers need fewer US dollars, causing the demand curve to shift to the left.
Step 3: US Interest Rate Differential
The second factor is the US interest rate differential, which is the difference between the US interest rate and foreign interest rates. If the US interest rate is significantly higher than foreign interest rates, the demand for US dollars increases because investors seek to take advantage of the higher returns available in the US. This causes the demand curve to shift to the right. On the other hand, if the US interest rate differential decreases, the demand for US dollars diminishes, shifting the demand curve to the left.
Step 4: Expected Future Exchange Rate
The third factor is the expected future exchange rate. If the future exchange rate is expected to be higher, the value of US dollars is anticipated to increase. This expectation leads to an increased demand for US dollars today, shifting the demand curve to the right. Conversely, if the future exchange rate is expected to be lower, the demand for US dollars decreases, causing the demand curve to shift to the left.
Step 5: Summary of Factors Affecting the Demand Curve
In summary, the demand curve for US dollars can shift due to changes in the world demand for US exports, the US interest rate differential, and the expected future exchange rate. An increase in the demand for US exports, a higher US interest rate differential, or an expected increase in the future exchange rate will shift the demand curve to the right. Conversely, a decrease in the demand for US exports, a lower US interest rate differential, or an expected decrease in the future exchange rate will shift the demand curve to the left.
FAQs
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What is an exchange rate?
An exchange rate is the value of one currency in terms of another currency. It represents the amount of one currency that can be exchanged for a unit of another currency. For example, if the exchange rate between the US dollar and the euro is 1 USD = 0.85 EUR, it means you can exchange 1 US dollar for 0.85 euros.
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How do interest rates affect exchange rates?
Interest rates have a significant impact on exchange rates. When a country's central bank raises interest rates, it typically leads to an appreciation of that country's currency. This is because higher interest rates attract foreign investment, increasing demand for the currency. Conversely, lower interest rates can lead to currency depreciation as investors seek higher returns elsewhere.
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What's the difference between nominal and real exchange rates?
Nominal exchange rates are the actual rates at which currencies are exchanged in the foreign exchange market. Real exchange rates, on the other hand, take into account the purchasing power of currencies by considering price levels in different countries. Real exchange rates provide a more accurate picture of the relative value of currencies in terms of goods and services they can buy.
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How do exchange rates affect international trade?
Exchange rates significantly impact international trade. When a country's currency appreciates, its exports become more expensive for foreign buyers, potentially reducing demand. Simultaneously, imports become cheaper for domestic consumers. Conversely, when a currency depreciates, exports become more competitive in international markets, while imports become more expensive. These changes can affect a country's trade balance and overall economic performance.
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What factors influence exchange rate fluctuations?
Several factors can cause exchange rates to fluctuate, including:
- Interest rates and monetary policy
- Inflation rates
- Political and economic stability
- Government debt
- Terms of trade
- Speculation and market sentiment
- Economic performance and growth prospects
Prerequisite Topics
Understanding the foundations of economics is crucial when delving into complex topics like changes in exchange rates. One key prerequisite topic that plays a significant role in this area is influencing factors in data collection. This concept is particularly relevant to exchange rates because it helps us comprehend how various factors can impact currency supply and demand, ultimately affecting exchange rates.
When studying changes in exchange rates, it's essential to recognize that the foreign exchange market is influenced by numerous factors, many of which are related to data collection and analysis. Understanding how to identify and interpret these factors influencing currency supply is crucial for anyone looking to grasp the complexities of exchange rate fluctuations.
For instance, economic indicators such as inflation rates, interest rates, and GDP growth are all examples of data that can significantly impact exchange rates. The methods used to collect and analyze this data can have a profound effect on how markets interpret and react to this information. By studying the influencing factors in data collection, students can develop a more nuanced understanding of how these economic indicators are gathered and how they might affect currency values.
Moreover, political events, trade balances, and market sentiment are additional factors that can influence exchange rates. The way this information is collected, reported, and disseminated can create ripples in the forex market. A solid grasp of data collection principles helps in critically evaluating the reliability and impact of such information on exchange rates.
Another aspect where influencing factors in data collection becomes relevant is in understanding market speculation and forecasting. Traders and analysts often rely on various data points to predict future exchange rate movements. The quality and interpretation of this data, influenced by collection methods, can significantly affect market expectations and, consequently, exchange rates.
Furthermore, in today's globalized economy, the interconnectedness of financial markets means that data from one country can impact exchange rates worldwide. Understanding how different countries collect and report economic data, and the potential biases or limitations in these processes, is crucial for a comprehensive analysis of exchange rate dynamics.
In conclusion, the study of influencing factors in data collection serves as a fundamental building block for understanding changes in exchange rates. It equips students with the critical thinking skills necessary to evaluate the quality and relevance of economic data, interpret market reactions, and analyze the complex web of factors that drive currency valuations. By mastering this prerequisite topic, students will be better prepared to navigate the intricate world of foreign exchange and develop a more sophisticated understanding of global economic dynamics.
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:
- World Demand for US Exports: With the number of the exports, we see that
- If the demand for US exports increase, then the demand for US dollars increase. (right shift)
- If the demand for US exports decrease, then the demand for US dollars decrease. (left shift)
- 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.
- If the US interest rate differential increase, then the demand for US dollars increase. (right shift)
- If the US interest rate differential decrease, then the demand for US dollars decrease. (left shift)
- 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.
- If expected future exchange rate increase, then the demand for US dollars increase. (right shift)
- 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:
- World Demand for US Imports: With the number of the imports, we see that
- If the demand for US imports increase, then the demand for US dollars increase. (right shift)
- If the demand for US imports decrease, then the demand for US dollars decrease. (left shift)
- 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.
- If the US interest rate differential decrease, then the supply for US dollars increase. (right shift)
- If the US interest rate differential increase, then the supply for US dollars decrease. (left shift)
- 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.
- If expected future exchange rate decrease, then the supply for US dollars increase. (right shift)
- 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
Where:
= exchange rate
= price level of domestic goods
= 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.