Changes in Exchange Rates

Changes in Exchange Rates

• Exchange rates (e) are a function of the supply and demand for currency.
• An increase in the supply of a currency will decrease the exchange rate of a currency
• A decrease in supply of a currency will increase the exchange rate of a currency
• An increase in demand for a currency will increase the exchange rate of a currency
• decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and Depreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases (e↑)
• Depreciation of a currency occurs when the exchange rate of that currency decreases (e↓)
• Ex. If German tourists flock to America to go shopping, then the supply of Euros will increase and the demand for Dollars will increase. This will cause the Euro to depreciate and the dollar to appreciate.

Exchange Rate Determinants

·         Consumer Tastes

o   Ex. A preference for Japanese goods creates an increase in the supply of dollars in the currency exchange market which leads to depreciation of the Dollar and an appreciation of Yen

·         Relative Income

o   Ex. If Mexico’s economy is strong and the U.S. economy is in recession, then Mexicans will buy more American goods, increasing the demand for the dollar, causing the Dollar to appreciate and the Peso to depreciate

·         Relative Price Level

o   Ex. If the price level is higher in Canada than in the United States, then American goods are relatively cheaper than Canadian goods, thus Canadians will import more American goods causing the U.S. Dollar to appreciate and the Canadian Dollar to depreciate.

·         Speculation

o   Ex. If U.S. investors expect that Swiss interest rates will climb in the future, then Americans will demand Swiss Francs in order to earn the higher rates of return in Switzerland. This will cause the Dollar to depreciate and the Swiss Fran to appreciate.

Tips

·         Always change the D line on one currency graph, the S line on the other currency’s graph

·         Move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer.

·         If D on one graph increase, S on the other will also increase

·         If D moves to the left, S will move to the left on the other graph