Exchange Rate Determined
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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.
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?
- Changes in trade
- The supply of dollars is determined by US demand for imports from the EU.
- The demand for dollars is determined by EU demand for US exports.
- Example: If the EU loses interest in buying US goods, then the demand for US exports will fall, as will the demand for US dollars in the foreign exchange market, and the dollar will depreciate. The Europeans need fewer dollars because they are buying fewer American goods.
- Speculation / foreign exchange traders
- Some people buy and sell currencies to make a profit – if they can buy a currency when the exchange rate is low and sell the currency when the exchange rate is high, they will make money.
- Speculators guess as to what the exchange rate will be in the future and buy and sell according to that guess, either demanding more or less dollars or supplying more or less dollars.
- Example: If speculators think that the exchange rate of the dollar will be less next week, they will try and sell their dollars now. This increases the supply of dollars in the foreign exchange market and the dollar will depreciate.
Note: a change in the exchange rate can also affect aggregate demand.