To see how exchange rates affect relative prices, consider this example:

Suppose as a U.S. car buyer we are deciding between a Toyota Corolla (made in Japan) and a Saturn SL2. Both are comparable compact sedans. Suppose also that

The price of the Saturn in Japan is

$13,500 x 120 yen/$ = 1,620,000 yen

Case 2: Now suppose the exchange rate changes to 110 Yen/$

In other words, each dollar gives you fewer yen than before. When this happens we say that

• the $ has depreciated against the yen
• the $ has fallen against the yen
• the $ is weaker against the yen

or from the perspective of Japan

• the yen has appreciated against the dollar
• the yen has risen against the dollar
• the yen is stronger against the dollar

The six bulleted statements above all mean the same thing.

Now we recalculate the prices of the Corolla and the Saturn:

The price of the Corolla in the U.S. is

1,800,000 yen x $1/110 yen = $16,363.64

the price of the Saturn in Japan is

$13,500 x 110 yen/$ = 1,485,000 yen

When the $ depreciated, the Corolla got more expensive in the U.S. while the Saturn got cheaper in Japan.

So we can see that the exchange rate has an impact on the relative prices of imports vs. domestic goods

To generalize the results from the example above:

• When the $ appreciates, imports are cheaper and our exports are more expensive abroad.
• When the $ depreciates, imports are more expensive and our exports are cheaper abroad.
• Exchange rates are a seesaw: If the dollar appreciates against the yen, then the yen MUST depreciate against the dollar.
• An exchange rate movement has both winners and losers: Corolla dealers are not happy about a depreciating $, but U.S. automakers are happy about it.

II. The Foreign-Exchange Markets

The exchange rate is in fact a price, and in most cases it is determined in a market by supply and demand.

Who demands U.S. dollars?

• Foreigners buying U.S. goods (our exports)
• Foreigners buying U.S. investments
• World investors trying to profit from expected exchange rate movements (speculators)
• Various governments trying to impact the exchange rate

Who supplies U.S. dollars?

• Americans buying imported goods
• Americans investing in other countries
• World investors trying to profit from expected exchange rate movements (speculators)
• Various governments trying to impact the exchange rate

We can draw the demand and supply of dollars, relative to the yen, below:

As we move up the vertical axis, the dollar appreciates. Note that the demand for dollars slopes down. As the dollar appreciates against the yen, the Japanese will buyer fewer American goods (because they are more expensive to them) so the quantity demanded of dollars will fall. The supply curve slopes up because as the dollar appreciates, Americans will buy more Japanese goods (because they are cheaper to us), and the quantity supplied of dollars will rise.

When exchange rates fluctuate (and they fluctuate A LOT), it is due to a shift in the supply and/or demand for U.S. dollars relative to Japan’s Yen. These shifts occur when

• Japan’s economy is growing faster/slower than the U.S. economy. This changes the balance of imports and exports between the two countries. If the U.S. economy is growing faster than Japans, we buy more imports and the supply of dollars increases. This causes the dollar to depreciate:

• If Japan is growing faster, then the demand for dollars will increase, and the dollar appreciates.
• Inflation in Japan is different from inflation in the U.S. This causes one country to increasingly substitute cheaper imports. If inflation is higher in the U.S. we buy more Japanese imports, the supply of dollars increases, and the dollar depreciates. If inflation is lower in the U.S. the Japanese buy more U.S. goods, the demand for dollars increases, and the dollar appreciates.
• Changes in product availability. An earthquake in Japan, or a flood in the U.S. will affect exports and imports. An earthquake in Japan may force it to import more food from the U.S. which increases the demand for dollars, and the dollar will appreciate:

• Speculators anticipate movements in the yen/$ exchange rate and they start buying or selling dollars or yen. If investors expect the dollar to appreciate, they start buying it. The demand for dollars increases, and the dollar appreciates.
• The governments of Japan and/or the U.S. wish to alter the yen/$ exchange rate and they start buying or selling dollars or yen. In the summer of 1994, the Federal Reserve bought dollars (increasing dollar demand) in order to strengthen the dollar which had fallen to 80 yen/$.

III. The Balance of Payments

Note that our equilibria in the previous section determined not only the exchange rate, but also the quantity of dollar transactions. The balance of payments is an accounting statement that summarizes these transactions. It has three parts:

The Trade Balance

We are already familiar with this. The trade balance = exports — imports. If it is negative, then we have a trade deficit. If it is positive, then we have a trade surplus. A trade deficit implies that more dollars are flowing out of the U.S. (to buy imports) and into the U.S. (to buy exports).

The Current Account Balance

This includes the trade balance plus other activities that involve the flow of dollars:

• investment income coming in from U.S.-owned foreign investments
• investment income going out from foreign-owned U.S. investments
• U.S. government aid going out to other countries
• wages earned in the U.S. and sent out to other countries.

We run a current account deficit, mostly due to the large amount of investment income going out from foreign-owned U.S. investments and our large trade deficit.

The Capital Account Balance

This tracks assets bought and sold across international borders.

Capital account balance = Foreign purchases of U.S. assets — U.S. purchases of foreign assets.

The flows of capital are what finances the flows of goods and services. If we import more than we exports there is a net outflow of dollars, the countries receiving these dollars use them to buy U.S. assets. In other words, the number of dollars demanded must equal the number of dollars supplied. Thus

Current account balance + capital account balance = 0

Also, recall that as the U.S. dollar appreciates against other currencies, imports become cheaper and our exports are more expensive, which further increases the trade deficit. So the exchange rate will affect the balance of payments.

IV. Exchange Rate Systems

Foreign exchange markets are characterized by the degree of government intervention in those markets to maintain certain exchange rates.

Fixed Exchange Rates

This is the most restrictive system for determining exchange rates. Under this system, exchange rates are fixed in value, and each country’s government is responsible for maintaining the fixed exchange rate.

One example of such a system is the Bretton Woods Agreement, which fixed the exchange rates of the U.S. dollar to several other European currencies from 1944-1973. The value of the U.S. dollar and other currencies were defined in terms of gold, which implied an exchange rate for any two countries.

The problem arises where market forces want to push the exchange rate above or below where it should be. Suppose the German Mark/$ exchange rate is fixed at 5 M/$:

Now suppose that German inflation is lower than U.S. inflation, causing the U.S. to purchase more German imports. The supply of dollars increases:

The market wants the dollar to depreciate, to 4 marks per dollar. However, the U.S. must maintain an exchange rate of 5 marks per dollar. At 5 marks per dollar, there is an excess supply of dollars. There are only 2 solutions to this problem:

(1) Allow the exchange rate to fall to 4 marks per dollar. This is known as a devaluation.

(2) Shift supply or demand to move equilibrium back to 5 marks per dollar

Option (1) defeats the purpose of a fixed exchange rate, which leads us to option (2). The U.S. government could buy U.S. dollars and sell German marks to increase the demand for dollars:

Now the equilibrium exchange rate is once again 5 marks per dollar. However, if the U.S. government does not have enough marks to sell, this will not work.

Another alternative is to use trade restrictions (like quotas or tariffs) to force U.S. consumers to buy domestic goods. This will shift the supply curve back to its original position. But trade restrictions decrease world output and could lead to retaliation by other countries.

Yet another alternative is to use fiscal or monetary policy. An increase in taxes will decrease disposable income and thus import demand. This would also shift supply back to its original position. A decrease in the money supply will increase interest rates. Higher interest rates dampen import spending while also attracting foreign investment. However, using fiscal or monetary policy to maintain the exchange rate means that the U.S. cannot use it to achieve domestic economic goals. This is why Bretton Woods fell apart in 1973.

Fixed exchange rate systems involve a fundamental tradeoff:

• The advantage is stable and predictable exchange rates, which facilitate international trade and investment.
• The disadvantage is that countries give up control of domestic fiscal and monetary policies in order to maintain exchange rates.

A current example of fixed exchange rates is the euro, the common currency of 11 European countries since 1999. A single currency is the ultimate in a fixed exchange rate. It will make trade between nations much easier, but each member nation must subordinate their national monetary policy to a single central bank.

Flexible Exchange Rates

Flexible exchange rates are also known as floating exchange rates. In this case the exchange rate is allowed to fluctuate freely with changes in supply and demand. There are no worries about maintaining such a system, but the fluctuations in exchange rates adds some degree of uncertainty to international trade However, this uncertainty can be managed in financial markets.

The U.S. dollar is on a flexible system with its major trading partners, and has been since 1973. However, the U.S. government will intervene if the dollar appreciates or depreciates too much against the currencies of our major trading partners.

Managed Exchange Rates

Also known as a dirty float or a managed float, managed exchange rates strike a medium between fixed and floating systems. In this case, the government maintains exchange rates within some acceptable range. For example the dollar must be worth between 100 yen and 120 yen. Exchange rate interventions by the U.S. government are much too rare to consider the U.S. dollar to be a managed currency.

Prior to the adoption of the euro in 1999, 13 European nations were part of a managed exchange rate system, which allowed their exchange rates to fluctuate within a narrow band. But even with some fluctuation allowed, some nations had problems. In 1992, Great Britain had to drop out temporarily.

FYI: Related Links

Policy Debate: Does Dollarization Benefit Developing Countries? A discussion of the advantages and disadvantages of small countries with shakey currencies adopting the U.S. dollar as their standard of value.

Euro Weakness Reflects Europe’s Weaknesses A Dismal Scientist article about the dollar/euro exchange rate and a good example of how economic factors influence exchange rates.