APMacro: Exchange Rates

ForeignExchangeMarket_2opt    Exchange rates are determined by supply and demand. While the key graph for this chapter shows the market for only one currency, it is helpful to draw the markets for both currencies side by side, to see the relative changes in the value of currencies. If Americans increase imports of British products, the Americans must increase their demand for British pounds to pay for those products. The increase in demand pushes up the value of the British pound, causing it to appreciate. In order to pay for those pounds, consumers must spend dollars in the international currency market. As the supply of dollars increases (in the dollar market graph), the value of the dollar decreases, or depreciates. All currency values are relative, so if the pound appreciates against the dollar, the dollar must depreciate against the pound.

Demand for a currency can shift as a result of a change in tastes, a change in relative incomes, a change in relative inflation rates, a change in relative interest rates, changes in expected returns on financial investments, and speculation. When incomes increase or domestic inflation rates are high, consumers buy more imports, and as a result, demand for foreign currency increases. In the same way, if households expect to earn higher returns on bonds or other investments in another country, or if they expect the value of the currency itself to increase as an investment, they will increase demand for the currency.

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