Foreign Exchange Market: Policies, Conditions, and Exchange Rates

Changes in the Foreign Exchange Market

Changes in the supply or demand for a currency cause it to appreciate or depreciate.

• Appreciation: An increase in the value of a currency relative to another.
• Depreciation: A decrease in the value of a currency relative to another.

Factors Affecting Currency Demand

The demand for a currency is influenced by other countries' desire to purchase goods, services, or assets using that currency.

• For example, if other countries want more goods, services, and assets from Roasterland, the demand for Roasterland's currency increases.

Factors Affecting Currency Supply

The supply of a currency depends on how much people using that currency want goods, services, or assets from other countries.

• For example, if Roasterland wants more goods, services, and assets from other countries, the supply of Roasterland's currency increases.

Key Terms

• Tariff: A tax on imported goods.
  • If Maxistan places a tariff on goods from other countries, it will supply less of its own currency because it will want to buy fewer foreign goods.
• Quota: A limit on the quantity of goods that can be imported.
  • If Maxistan places a restrictive quota on goods from other countries, it will supply less of its own currency because it will buy fewer foreign goods.
• Real Exchange Rate: The nominal exchange rate of a currency adjusted for the relative price levels in each country.

Changes in the Demand for a Currency

Figure 1: An increase in the demand of the Roasterland bean (RB), causing the RB to appreciate.

The mnemonic TIPSY can be used to remember the factors that shift the demand for a currency:

• Tastes and preferences
• Interest rates
• Price levels
• Speculation
• National Income (Y)

Factors That Shift the Demand for a Currency

Changes in the Supply of a Currency

• National income ($Y$):
  • More national income leads to a higher demand for another country's goods, and therefore their currency.
    • An economic boom in Petmickistan increases their demand for Jacksonian cream cheese. The demand for the Jacksonian jay (JJ) increases, and the JJ appreciates.

Figure 2: Changes in the supply of a currency

• To demand a currency in another market, you must supply your currency in your own.
• The supply of a currency is based on domestic buyers wanting to buy stuff from other countries, such as Americans wanting to buy coffee or government bonds from Roasterland.

Factors That Shift the Demand and Supply for Currencies

Key Takeaways

• Demand for a currency:
  • Derives from foreign buyers of goods, services, and assets.
  • To buy goods, services, and assets inside a country, foreign buyers need that country’s currency.
    • To buy coffee from Guatemala, someone in the United States needs Guatemalan Quetzals (GTQ).
• Supply of a currency:
  • Derives from domestic buyers of foreign goods, services, and assets.
  • To buy foreign goods, domestic buyers need to supply their own currency to get the foreign currency.
    • To buy coffee from Guatemala, someone in the United States has to supply dollars to obtain GTQ.
• Monetary and fiscal policy can impact exchange rates
  • Monetary and fiscal policy impact output, inflation, unemployment, and interest rates.
  • If monetary policy or fiscal policy impacts the price level, that country’s relative price level is higher relative to other countries, making its goods more expensive.
  • This leads to a decrease in the demand for that currency, and therefore a depreciation of that currency.

Key Equation

The real exchange rate (R.E.R.) of a currency depends on the nominal exchange rate and the relative price levels in two countries:

R.E.R.$ = \text{other currency per dollar} \times \dfrac{PL{U.S.}}{PL_{\text{other country}}}

• Example:

  • CPI in the United States is 110.
  • CPI in Ghana is 100.
  • The nominal exchange rate of the dollar is currently 5 cedi per dollar.
  • The real exchange rate of the dollar is:

  \begin{aligned}
  R.E.R_\$&=5\text{ cedi per }\$ \times \dfrac{110}{100} \
  &=5 \text{ cedi per }\$\times 1.1\
  & = 5.5 \text{ cedi per }\$
  \end{aligned}

• If the price level in the United States increases, the real exchange rate of the dollar increases, and the dollar appreciates. Example:

  • CPI in the United States increases to 120:

  \begin{aligned}
  R.E.R_\$&=5\text{ cedi per }\$ \times \dfrac{120}{100} \
  &=5 \text{ cedi per }\$\times 1.2\
  & = 6 \text{ cedi per }\$
  \end{aligned}