The Determination of Exchange Rates

Supply and Demand View of Exchange Rates Sreejata Banerjee

Exchange Rate Definition

Exchange rate is the price of a countrys currency which depends on the supply of and demand for that currency, at least when exchange rates are determined freely in an un-regulated market.

Exchange Rate Definition: Fixed or Flexible

When exchange rates are fixed, as they were under the Gold Standard, The Bretton Woods standard and the European Monetary System, they are also determined by the supply and demand. The difference between fixed and flexible rates is that with fixed rates there is an official demand or supply at the fixed rate rate and thus is adjusted to ensure that the rate stays at or near the chosen rate

Imports, Exports & Exchange Rates

To determine the exchange rate let us first derive the supply curve of the currency of a country. The supply curve shows the amount of that currency supplied on the horizontal axis and the price of that currency on the vertical axis.

Supply Curve

The supply curve of currency derives partly from the country's demand for imports. Because when paying for imports that are invoiced in foreign currency the countrys citizens must sell their currency to buy the foreign exchange to pay for imports. Even when imports are invoiced in home currency recipients sell it.
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UK Import Demand for Wheat and Supply of GBP

Exchange Rate $/
Price of Price in Wheat in US$

Import Demand billions of bushel

Supply of

billion per year

1.5
1.7

3$
3$

$3/1.5 = 2
$3/1.7 = 1.76 $3/2 = 1.5

0
0.75

0
1.32

2.0

3$

1.5

2.25
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Wheat Import of UK

Supply of GBP

Demand Curve

The demand curve for a currency shows the value of the currency that is demanded at each possible exchange rate. Because the need to buy the currency stems from the need to pay for the exports of that currency at each price. Let us assume UK exports oil the demand for GBP to pay for the oil exports at each exchange rate. We need to construct the demand curve for we need the value of oil exports at each exchange rate. 9

UK Export Supply of Oil and Demand for Pounds

Exchange Rate $/ Price of Oil in $ Price of Oil in Oil Export billions of barrels Demand for

$25

25/2= 12.5

1.8
1.5

$25
$25

25/1.8 = 13.89
25/1.5 =16.67

0.1
0.2

1.389
3.333

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Oil Exports of UK

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Demand for GBP

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Factors Effecting Exchange Rate

If we plot the supply and demand curve of on the same plane we get the equilibrium exchange rate , the value of imports and value of exports. We observe that the approx equilibrium exchange rate is $1.75/ . Ceteris Paribus if exogenously value of exports rise at each exchange rate the demand curve shifts RHS will given the slopes of the curve lead to an appreciation of the British pound. This increase in exports may be due to higher world price of oil or increase in the volume of exports.
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Factors Effecting Exchange Rate

Similarly ceteris paribus if the import of wheat increases exogenously and the supply of pound curve shifts to the right it will lead to a decrease in he value of the pound. A countrys terms of trade are said to deteriorate when the price of its imports are relatively higher then the exports and vice versa.

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Inflation

Exchange rates also influenced by inflation, which effects the competitiveness of one countrys product against similar product of another country. Suppose Britain experiences a 25% inflation, the British demand curves for wheat and oil will be 25% higher than it was at the beginning of the year. At the same time the supply curve will also shift upwards. The marginal cost curves which form the shortrun supply curve then we can think that the Marginal revenue curve will also be 25% higher.
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Inflation in one country

If inflation occurs in one country say in UK, we assume that the price of wheat and oil remain the same in the USA. Suppose there is 25% inflation it causes a 20% depreciation of the pound. This happens because the $ price of wheat remains unchanged and a 20% depreciation of the exactly sets off the inflation.
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Inflation

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Inflation also in other country

Suppose US inflation is also 25% so that dollar prices of wheat & oil increase to $3.75 per bushel & $31.25 per bushel. We find that the exchange rate in both countries remain unchanged but if it happens in one country that countrys exchange rate depreciates. Generally it can be concluded that a countrys exchange rate depreciates by about by approximately the extent that the countrys inflation exceeds that of the other country. This statement assumes that other things remain constant.
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Service Trade and Income Flows & Transfers

Import and Export of services like tourism, banking, consulting etc. respond to exchange rate the same way that merchandise import & export do. Therefore the currency supply and demand curves derived from international trade in these services look similar to that of curves for merchandise.

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Service Trade and Income Flows & Transfers

The supply and demand curve for a currency from payments & receipts of interests, dividends, rents and profits do not respond to exchange rate as other goods and merchandise do. Income payments are largely determined by past investments, and they may be considered to be independent of exchange rate. Hence higher income receipts from exports to income payments lead to higher exchange rate.
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Service Trade and Income Flows & Transfers

If exports of services exceed imports of services the demand curve for D is shifted more to the right than the supply curve for S.Therefore it leads to a higher exchange rate for the . Transfer payments can easily be accommodated into the demand and supply for currency model. The amount of transfer received from abroad is added to he demand for currency and net out flows into the supply curve.
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Transfer Payments
Transfer payments depend on a countrys need for help or its ability to help others. Transfer payments also depend on the number of residents sending funds to relatives persons or receiving funds from relatives abroad.

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Foreign Investment

Foreign investment in a country represents a demand for the countrys currency when the investment occurs. In all future periods when interest , dividend are paid or profit & rent are repatriated, there is a supply of the countrys currency. The amount of investment flowing into or out of a country depends on the rate of return in the country relative to rate of return elsewhere as well as relative risk.
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Foreign Investment

Similarly, for given interest rates and expected profits and expected appreciation for the countrys currency increases the attractiveness as an investment destination investment. Hence the expected future appreciation of a countrys currency, cause a countrys currency to appreciate further, just as it is true for other assets.

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