Robert J. Stonebraker, Winthrop University

Demand and Supply Applied:

Exchange Rates

Let’s go someplace else.

my wife after seeing the exchange rate

My wife loves London. In her earlier life she often led student tours to London. Though her days of herding undergraduates through Westminster Abbey ended after marrying me, London remains a favorite vacation destination. When she suggested a return trip a few years ago, I did what any economist would do; I checked the exchange rates. Because London hotels naturally price their rooms in terms of British pounds (₤) rather than American dollars, our travel costs depend upon the exchange rate: how many dollars will it take to trade for a pound.

When last we traveled, it took only $1.44 to buy ₤1. Alas, when I checked for this trip, it took $2.00 to buy that same ₤1. 1 That’s a 39% change. A London hotel room renting for 100₤ a night would have cost us $144 at the old exchange rate, but would cost $200 at the new exchange rate. Using econ-speak, the British pound had appreciated or gained value with respect to the U.S. dollar while the dollar had depreciated or lost value with respect to the pound.

After hearing that a stay in London would cost an extra 39%, my wife quickly began exploring alternative vacation plans. Even for my non-economist wife, the quantity demanded goes down when the price goes up. Recognizing that powerful economic forces were at work, she excitedly bubbled: Will you please show me the graph? 2

Exchange rates and international trade patterns

Hang on, the graphs are coming soon. But first, for even more excitement, let’s do some arithmetic.

Suppose that a wool sweater can be purchased in the U.S. for $90 and that an equivalent sweater is available in London for ₤50. Ignoring transportation costs, which sweater is less expensive? Is $90 more or less than ₤50? It depends. What’s the exchange rate? If the exchange rate is $1.50 = ₤1, the British sweater is the less expensive. At $1.50 = ₤1, the London sweater would cost an American only $75 [₤50 would cost (1.50)(50) = $75] as opposed to $90 for the U.S. sweater. Similarly, at that same exchange rate, a London shopper would have to part with ₤60 for the U.S. sweater [$90 would cost 90 ч 1.5 = ₤60] instead of only ₤50 for the local sweater. At these prices, Americans will be importing sweaters from Great Britain. Alternatively, the British will be exporting sweaters to the U.S.

Next, suppose the exchange rate shifts to $2 = ₤1. The British pound has appreciated and is more valuable (it’s now worth $2 instead of only $1.50) while the dollar has depreciated or lost value (it now takes more dollars to buy the same British pound). More interestingly, trade patterns will reverse. At the $2 = ₤1 rate, U.S. sweaters become the better buy. American consumers now must pay $100 for the British sweater [50₤ now cost (2)(50) = $100], but can get the U.S. sweater for only $90. Similarly, British shoppers now can get the American sweater for only ₤45 [$90 now cost 90 ч 2 = ₤45] while the local version costs ₤50. At the new exchange rate, Americans will export the sweaters and the British will import.

Do you see the pattern? Appreciation makes your country’s currency (and products) more expensive on world markets. You will export less and import more. Depreciation does the opposite. It makes your currency (and products) less expensive on world markets. You export more and import less.

Is one scenario better than the other? Not really. It depends upon whether you are a buyer or a seller. As a buyer, I want my currency to appreciate; it gives me more buying power in other countries. Appreciation means that I can get more foreign currencies, and more foreign goods, for my dollars. But sellers prefer depreciation. A depreciated dollar means that it is less expensive for people in other countries to buy U.S. dollars and, therefore, U.S. products. Depreciation allows U.S. firms to sell more products in the international marketplace.

Equilibrium Exchange Rates

What determines exchange rates? What causes currencies to appreciate or depreciate? Aha. It’s demand and supply. Graphs at last.

Like most nations, the U.S. and Great Britain allow the value of their currencies to float in the international markets. The equilibrium prices of the currencies depend upon demand and supply; just like the prices of other goods and services. The demand for a currency on the international exchange markets depends upon the demand for that country’s products in the international markets. Why would an American want British pounds? Primarily to buy British products that are priced in terms of pounds. The greater is our demand for British goods, the greater will be our demand for British pounds.

Similarly, the supply of a country’s currency on the international markets depends upon the willingness its people to buy foreign products. Why would the British want to supply Americans with their pounds? Primarily to be able to buy something from the U.S. The more foreign products the British demand, the more British pounds they will be willing to supply.

The demand and supply curves for currencies have the familiar shapes. Check the graph below:

20images/exchange1.gif /%

As always, the equilibrium price will be where the curves intersect (an exchange rate of $1.50 = ₤1 in the above graph). At any higher price there would be an excess supply of British pounds that would drive the price down. And, at any lower price, there would be an excess demand for pounds that would drive the price up.

And, as always, shifts in the demand or supply curves will change the equilibrium price or exchange rate. For example, suppose that Americans decide to go on an international spending spree and stock up on British tea sets. What will happen? How will exchange rates move? Can you picture the graph?

The answer is below. The new demand for tea sets will increase demand for the British pounds needed to buy them. This shifts the demand for pounds from D₀ to D₁ and, at the original exchange rate (ER₀ ) creates an excess demand for pounds. How do we induce the British to part with their pounds? We offer them a better deal. The new demand drives up the equilibrium rate to ER₁. With the dollar price of the pound rising, the British pound has appreciated and the dollar has depreciated.

20images/exchange2.gif /%

To a large degree the example above describes what has happened in recent years. Rising American demands for foreign-produced goods and services has increased the demand for foreign currencies and caused the dollar to depreciate in international markets.

How about another example? One is never enough. Suppose that London financiers learn that interest rates being earned on financial assets in America are higher than those Great Britain. Can you predict the outcome?

To purchase American financial assets, the British first must trade in their pounds to get U.S. dollars. This increases the supply of pounds on the international exchange markets (the supply of pounds rises from S₀ to S₁ in the diagram below). In turn, the increased supply of pounds will drive down the price and the exchange rate moves from ER₀ to ER₁. Since Americans can now pay fewer dollars to buy the pound, the pound has depreciated and the dollar has appreciated.

20images/exchange3.gif /%

Are you still with me? The prices or values of currencies are determined by demand and supply, just like other products. And, just like other products, those equilibrium prices do not change spontaneously. They change if and only if there is a change in the underlying factors that determine demand and supply. Factors that make us want more foreign goods, services and assets more attractive (eg. more income, lower foreign prices, greater perceived value of foreign goods, higher foreign interest rates, etc.) will increase the demand for the foreign currency and cause it to appreciate. Factors that make foreign goods, services, and assets less attractive to us will lower the demand for the foreign currency and cause it to depreciate. Similarly, factors that make U.S. products and assets more attractive to foreigners will increase their willingness to supply their currencies and cause their currencies to depreciate, while factors that make U.S. products and assets less attractive to foreigners will induce them to cut their willingness to supply their currencies and cause them to appreciate.

Dollars in and dollars out

This is pretty exciting, right? Relax a minute and take a deep breath. It gets even better. Note that at the equilibrium the quantity of a currency demanded equals the quantity supplied. The value of British products that Americans want exactly equals the value of American products that the British want. The value of what we export to the British equals the value of what we import; trade between our countries automatically is balanced.

Think through an example similar to the first one we considered. Suppose that British products suddenly drop in price and, as a result, Americans decide to buy more. Work through the steps:

1. As we try to import more, the initial effect is to push us toward a trade deficit with Great Britain. We want to buy more of their products than they want of ours. 3

2. Our new demand for British products will cause an increase in our demand for British pounds.

3. With increased demand, the British pound will appreciate; the pounds will become more expensive for Americans to buy.

4. As the British pounds become more expensive, British products (that are priced in pounds) also will become more expensive for us.

5. The increased expense cuts our desire to buy British products and brings our imports back into line with exports. 4

Did you catch on? Exchange rate markets always drag trade between countries back into balance. A drop in the price of British products can cause an initial trade imbalance, but the imbalance will be only temporary. The British pound will appreciate, this will make British goods more expensive to us, and balance will be restored at a new equilibrium exchange rate. At equilibrium, the value of products being exported always equals the value being imported.

While we have stuck to a two-country U.S. vs. Great Britain example, the same concepts hold for trade in a multi-national world. What applies to trade between the U.S. and Great Britain, also applies to trade between the U.S. and China, and between Great Britain and China.

Wait. Can that be true? Media reports are filled with tales of trade imbalances with countries such as China. Doesn’t the U.S. run huge trade deficits with China?

Yes and no. It’s a matter of definition. If we look only at trade of currently produced goods and services, the U.S. does run international trade deficits with China and with many other countries as well. We import more currently produced goods and services than we export. However, there also is a healthy trade in assets across international boundaries. We can buy and sell currently produced items like oil, textiles, and automobiles on international markets; we also can buy and sell assets like real estate, corporate stocks and bonds, and other financial assets on international markets. In recent decades the U.S. has run consistent deficits in the international trade of currently produced goods and services, but surpluses in the trade of assets. In effect, imports of products such as oil and textiles are balanced by exports of assets. We import Saudi Arabian oil and Chinese textiles; we export ownership of U.S. real estate and financial assets. It may not be the type of trade balance we prefer, but it is a balance nonetheless.

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Notes:

www.oanda.com/convert/classic.

2. Just kidding.

3. Importing more than we export is said to create a trade deficit. Exporting more than we import creates a trade surplus.

4. Strictly speaking, the appreciation of the British pound will cause an increase in our exports to Great Britain as well as a decrease in our imports. As the pound appreciates, the British can buy more dollars with their pounds. This makes American goods less expensive to them and enables us to sell more in Great Britain.

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Testing Yourself

To test your understanding of the concepts in this reading, try answering the following:

1. Explain which country will import and which will export a product given an exchange rate and prices in the respective countries. For example, if Mexican tomatoes cost 10 pesos per pound and American tomatoes cost $1 per pound, explain where the tomatoes are less expensive if the exchange rate is 12 pesos = $1.

2. Explain how and why appreciation and depreciation of currencies can change trade patterns between countries.

3. Identify which groups benefit from an appreciation of their currency, which benefit from a depreciation, and explain why.

4. Use supply and demand curves to illustrate and explain how exchange rates are determined.

5. Explain what factors might cause currencies to appreciate or depreciate and use supply and demand curves to illustrate.

6. Explain how exchange rates will ensure that the value of imports entering a country will roughly equal the value of exports leaving the country.

Permission to reproduce or copy all or parts of this material for non-profit use is granted on the condition that the author and source are credited. Suggestions and comments are welcomed.

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