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Currency Exchange

DETERMINANTS OF THE VALUE OF
FOREIGN EXCHANGE
Demand Supply
Supply and demand in the foreign-exchange market are
determined by changes in many market variables, includ-
ing relative price levels, real interest rates, productivity,
.012
Price per Yen (in $) .010 Equilibrium which are an important factor in determining exchange
product preferences, and perceptions of economic stability.
Different countries have different rates of inflation,
rates. Purchasing power parity (PPP) is one widely used
theory of the determination of exchange rates. PPP exists
between any two currencies whenever changes in the
exchange rate exactly reflect relative changes in price lev-
els in two countries. In the long run, the average value of
exchange rates depends on their purchasing power parity
100 125 150
Billions of Yen per Year because in that way the relative prices in the two countries
will stay the same (when measured in a common cur-
rency). That is, changes in the relative values of the two
Figure 1
currencies compensate exactly for differences in national
exchange rates. The PPP theory seems to work well in the
long run when the differences in inflation rates between
two countries are relatively large. When differences in
ates a supply of yen and a demand for dollars in the inflation rates are relatively small, other market-oriented
foreign-exchange market. The equilibrium exchange rate forces may dominate and often distort the picture.
will tell us how many yen a dollar can be exchanged for A factor that may affect equilibrium currency prices
(the dollar price of yen) or how many dollars a yen can be is the interest rate of a country. If the U.S. interest rate,
exchanged for (the yen price of dollars). corrected for people’s expectations of inflation, abruptly
The demand for and supply of foreign-exchange increased relative to interest rates in the rest of the world,
determine the equilibrium foreign exchange rate. For the international investors elsewhere would increase their
moment, ignore any speculative aspects of foreign demand for dollar-denominated assets, thereby increasing
exchange; that is, assume that there are no individuals the demand for dollars in foreign-exchange markets. An
who wish to buy yen simply because they think that the increased demand in foreign-exchange markets, other
price of yen will go up in the future. things held constant, would cause the dollar to appreciate
The idea of an exchange rate is similar to the idea of and other currencies to depreciate.
paying a market-determined price for something you Another factor affecting equilibrium is a change in
want to buy. If you like soda, you know you have to pay relative productivity. If one country’s productivity
about fifty cents a can. If the price went up to one dollar, increased relative to another’s, the former country would
you would probably buy fewer sodas. If the price went become more competitive in world markets. The demand
down to twenty-five cents, you might buy more. In other for its exports would increase, and so would the demand
words, the demand curve for soda, expressed in terms of for its currency.
dollars, slopes downward, following the law of demand. Changes in consumers’ tastes also affect the equilib-
The demand curve for Japanese yen also slopes down- rium prices of currencies. If Japan’s citizens suddenly
ward. Suppose it costs you one cent to buy one yen—this developed a taste for a U.S. product, such as video games,
would be the exchange rate between dollars and yen. If this would increase the demand for U.S. dollars in
tomorrow you had to pay two cents for a yen, then the foreign-exchange markets.
exchange rate would have changed. Looking at such an Finally, economic and political stability affect the
increase with respect to the yen, we would say that there supply of and demand for a currency, and therefore the
has been an appreciation in the value of the yen in the equilibrium price of that currency. If the United States
foreign-exchange market. But this increase in the value of looked economically and politically more stable than
the yen means that there has been a depreciation in the other countries, more foreigners would want to put their
value of the dollar in the foreign-exchange market. When savings into U.S. assets than in assets of another country.
one currency appreciates, the other currency depreciates. This would increase the demand for dollars.

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 183