6.4 Changes in an Exchange Rate

Supply and demand for currency

Exchange rates are determined by the supply and demand for a currency in the foreign exchange (forex) market. When demand for a country's currency rises (or supply falls), the currency appreciates (gains value). When demand falls (or supply rises), the currency depreciates (loses value).

What shifts currency demand/supply

Demand for a currency rises when foreigners want to buy that country's goods, invest in its assets, or earn higher real interest rates there. Supply of a currency rises when domestic residents want to buy foreign goods/assets. Changes in relative income, relative inflation, relative interest rates, and preferences shift these curves and change the exchange rate.

Linking to trade flows

An appreciation makes a country's exports more expensive and imports cheaper, worsening net exports; a depreciation makes exports cheaper and imports more expensive, improving net exports. This connects the loanable funds market, interest rates, and net capital flows to exchange rate changes.

Key terms

Currency appreciation

An increase in the value of one currency relative to another, caused by increased demand or decreased supply of that currency.

Currency depreciation

A decrease in the value of one currency relative to another, caused by decreased demand or increased supply of that currency.

Determinants of currency demand

Foreign demand for a country's goods/services, foreign investment in its assets, and relative real interest rates.

Effect of appreciation on trade

Exports become more expensive and imports cheaper, tending to decrease net exports.

Relative interest rates and exchange rates

Higher real interest rates in a country attract foreign capital, increasing demand for its currency and causing appreciation.

Try an AP-style question

Higher inflation in the U.S. relative to Mexico will cause the dollar to…

1. depreciate against the peso
2. be pegged
3. appreciate against the peso
4. stay the same