Exchange Rate Determined

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depreciation

exchange rate

international trade

How is the exchange rate determined?

The exchange rate changes from day to day, hour to hour, even minute to minute – Why is that?

Just like the market for any good, the exchange rate is determined by supply and demand!

Let’s say there are only two “countries” in the world: the US and the EU. There exists a market for US dollars in the world.  There is a certain amount of dollars that Europeans want and a certain number of dollars that Americans want to make available to Europeans. The “price” in this market is the nominal exchange rate – if the exchange rate is high, Europeans want less (just as you would buy less apples if they were expensive), and Americans want to make more available because they will get more for it (they are like the apple grower). Where supply equals demand we get an equilibrium exchange rate and quantity of dollars bought and sold in the foreign exchange market.

Figure 1 - Foreign exchange, supply and demand

As the demand and supply of dollars in the foreign exchange market moves around, so does the exchange rate!

If either demand rises (shift right) or supply falls (shift back) the nominal exchange rate appreciates (e goes up)

If either demand falls (shift left) or supply rises (shift out) the nominal exchange rate depreciates (e goes down)

What leads to changes in demand and supply?

Figure 2 - Depreciation due to lower demand
Figure 3 - Depreciation due to increasing supply

Note: a change in the exchange rate can also affect aggregate demand.

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