Although it is easy to measure the percentage change in a currency’s value, it is more difficult to explain why the value changed or to forecast how it may change in the future.
To achieve either of these objectives, the concept of anequilibrium exchange ratemust be understood in addition to the factors that affect this rate.
Before considering why an exchange rate changes, recall that an exchange rate (at a given time) represents the priceof a currency, or the rate at which one currency can be exchanged for another. The exchange rate always involves two currencies, but the focus in this text is the U.S. perspective. So unless specified otherwise, the“exchange rate”of any currency is the rate at which it can be exchanged for U.S. dollars.
Exhibit 4.1 How Exchange Rate Movements and Volatility Are Measured V A L U E O F C A N A D I A N
D O L L A R ( C $ )
M O N T H L Y % C H A N G E I N C $
V A L U E O F E U R O
M O N T H L Y % C H A N G E I N E U R O
Jan. 1 $0.70 — $1.18 —
Feb. 1 $0.71 1.43% $1.16 1.69%
March 1 $0.70 0.99% $1.15 0.86%
April 1 $0.70 0.85% $1.12 2.61%
May 1 $0.69 0.72% $1.11 0.89%
June 1 $0.70 þ0.43% $1.14 þ2.70%
July 1 $0.69 1.29% $1.17 þ2.63%
Standard deviation of monthly changes
1.04% 2.31%
WEB
www.bis.org/
statistics/eer/index.
htm
Information on how each currency’s value has changed against a broad index of currencies.
WEB
www.federalreserve.
gov/releases Current and historic exchange rates.
Like any other product sold in markets, the price of a currency is determined by the demand for that currency relative to its supply. Thus, for each possible price of a British pound, there is a corresponding demand for pounds and a corresponding supply of pounds for sale (to be exchanged for dollars). At any given moment, a currency should exhibit the price at which the demand for that currency is equal to supply; this is the equilibrium exchange rate. Of course, conditions can change over time. These changes induce adjustments in the supply of or demand for any currency of interest, which in turn creates movement in the currency’s price. A thorough discussion of this topic follows.
4-2a Demand for a Currency
The British pound is used here to explain exchange rate equilibrium. The United Kingdom has not adopted the euro as its currency and continues to use the pound. The U.S. demand for British pounds results partly from international trade, as U.S. firms obtain British pounds to purchase British products. In addition, there is U.S. demand for pounds due to international capital flows, as U.S. firms and investors obtain pounds to invest in British securities. Exhibit 4.2 shows a hypothetical number of pounds that would be demanded under several different values of the exchange rate. At any point in time, there is only one exchange rate; the exhibit shows how many pounds would be demanded at various exchange rates for a given time. Thisdemand scheduleis downward sloping because corporations and individuals in the United States would purchase more British goods when the pound is worth less (since then it takes fewer dollars to obtain the desired amount of pounds). Conversely, if the pound’s exchange rate is high then corporations and individuals in the United States are less willing to purchase British goods (since the products or securities could be acquired at a lower price in the United States or other countries).
Exhibit 4.2 Demand Schedule for British Pounds
$1.60
Value of £
$1.55
$1.50
Quantity of £ D
4-2b Supply of a Currency for Sale
Having considered the U.S. demand for pounds, the next step is to consider the British demand for U.S. dollars. This can be viewed as a Britishsupply of pounds for sale,since pounds are supplied in the foreign exchange market in exchange for U.S. dollars.
A supply schedule of pounds for sale in the foreign exchange market can be devel- oped in a manner similar to the demand schedule for pounds. Exhibit 4.3 shows the quantity of pounds for sale (supplied to the foreign exchange market in exchange for dollars) corresponding to each possible exchange rate at a given time. One can clearly see a positive relationship between the value of the British pound and the quantity of British pounds for sale (supplied), which is explained as follows. When the pound’s val- uation is high, British consumers and firms are more willing to exchange their pounds for dollars to purchase U.S. products or securities; hence they supply a greater number of pounds to the market to be exchanged for dollars. Conversely, when the pound’s val- uation is low, the supply of pounds for sale (to be exchanged for dollars) is smaller, reflecting less British desire to obtain U.S. goods.
4-2c Equilibrium
The demand and supply schedules for British pounds are combined in Exhibit 4.4 for a given moment in time. At an exchange rate of $1.50, the quantity of pounds demanded would exceed the supply of pounds for sale. Consequently, the banks that provide for- eign exchange services would experience a shortageof pounds at that exchange rate. At an exchange rate of $1.60, the quantity of pounds demanded would be less than the sup- ply of pounds for sale; in this case, banks providing foreign exchange services would experience asurplusof pounds at that exchange rate. According to Exhibit 4.4, the equi- librium exchange rate is $1.55 because this rate equates the quantity of pounds demanded with the supply of pounds for sale.
Exhibit 4.3 Supply Schedule of British Pounds for Sale
$1.60
Value of £
$1.55
$1.50
Quantity of £ S
4-2d Change in the Equilibrium Exchange Rate
Changes in the demand and supply schedules of a currency force a change in the equi- librium exchange rate in the foreign exchange market. Before considering the factors that could cause changes in the demand and supply schedules of a currency, it is important to understand the logic of how such changes affect the equilibrium exchange rate. There are four possible changes in market conditions that can affect this rate, and each condition is explained with an application to the British pound. The exchange rate varies because banks that serve as intermediaries in the foreign exchange market adjust the price at which they are willing to buy or sell a particular currency in the face of a sudden short- age or excess of that currency. When reading the descriptions that follow, assume that a single bank accommodates all customers seeking to buy British pounds (to exchange dollars for pounds) as well as all who are looking to sell them (to exchange pounds for dollars). This assumption makes it easier to understand why the exchange rate adjusts to shifts in the demand or supply schedules for a particular currency. Note that the bid/ask spread quoted by banks is not needed to explain this connection.
Increase in Demand Schedule The U.S. demand for British pounds can change at any time. Assume that the demand for British pounds in the foreign exchange market increases (depicted graphically as an outward shift in the demand schedule) but that the supply schedule of British pounds for sale has not changed. Then the amount of pounds demanded in the foreign exchange market will be more than the amount for sale in the foreign exchange market at the prevailing price (exchange rate), resulting in a shortage of British pounds. The banks that serve as intermediaries in the foreign exchange market will not have enough British pounds to accommodate demand for pounds at the prevail- ing exchange rate. These banks will respond by raising the price (exchange rate) of the pound. As they raise the exchange rate, there will be a decline in the amount of British pounds demanded in the foreign exchange market as well as an increase in the amount
Exhibit 4.4 Equilibrium Exchange Rate Determination
$1.60
Value of £
$1.55
$1.50
Quantity of £ S
D
of British pounds supplied (sold) in the foreign exchange market. The banks will increase the exchange rate to the level at which the amount of British pounds demanded is equal to the amount of British pounds supplied in the foreign exchange market.
Decrease in Demand Schedule Now suppose that conditions cause the demand for British pounds to decrease (depicted graphically as an inward shift in the demand schedule) but that the supply schedule of British pounds for sale has not changed.
Under these conditions, the amount of pounds demanded in the foreign exchange mar- ket will be less than the amount for sale in the foreign exchange market at the prevailing price (exchange rate). The banks that serve as intermediaries in this market will have an excess of British pounds at the prevailing exchange rate, and they will respond by lower- ing the price (exchange rate) of the pound. As they reduce the exchange rate, there will be an increase in the amount of British pounds demanded in the foreign exchange mar- ket and a decrease in the amount of British pounds supplied (sold) in that market. The banks will reduce the exchange rate to the level at which the amount of British pounds demanded is equal to the amount supplied in the foreign exchange market.
Increase in Supply Schedule The demand of British firms, consumers, or govern- ment agencies for U.S. dollars can change at any time. Assume that conditions cause that British demand for U.S. dollars to increase. Then there is an increase in the amount of British pounds to be supplied (exchanged for dollars) in the foreign exchange market (depicted graphically as an outward shift in the supply schedule) even though the demand schedule for British pounds has not changed. In this case, the amount of the currency supplied in the foreign exchange market will exceed the amount of British pounds demanded in that market at the prevailing price (exchange rate), resulting in a surplus of British pounds. The banks that serve as intermediaries in the foreign exchange market will respond by reducing the price of the pound. As they reduce the exchange rate, there will be an increase in the amount of British pounds demanded in the foreign exchange market. The banks will reduce the exchange rate to the level at which the amount of British pounds demanded is equal to the amount of British pounds supplied (sold) in the foreign exchange market.
Decrease in Supply Schedule Now assume that conditions cause British firms, con- sumers, and government agencies to need fewer U.S. dollars. Hence there is a decrease in the supply of British pounds to be exchanged for dollars in the foreign exchange market (depicted graphically as an inward shift in the supply schedule), although the demand sched- ule for British pounds has not changed. In this case, the amount of pounds supplied will be less than the amount demanded in the foreign exchange market at the prevailing price (exchange rate), resulting in a shortage of British pounds. Banks that serve as intermediaries in the foreign exchange market will respond by increasing the price (exchange rate) of the pound. As they increase the exchange rate, there will be an reduction in the amount of British pounds demanded and an increase in the amount of British pounds supplied. The banks will increase the exchange rate to the level at which the amount of British pounds demanded is equal to the amount of British pounds supplied (sold) in the foreign exchange market.