SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 18)

Changes in Supply and Demand and How They Affect the Exchange Rate

by

Charles Lamson

Starting with supply, let us now consider why changes in the supply of dollars in the foreign exchange market affect the exchange rate. The initial question that needs to be addressed is what factors, in addition to the exchange rate, could cause U.S. residents to alter their demand for foreign goods, services, and securities and thus, their supply of dollars in the foreign exchange market. In other words, what factors could cause the supply curve of dollars to shift? Previous research suggests that the following factors play a major role:

1. Changes in U.S. real income. Changes in U.S, real income and changes in the supply of dollars are positively related. The reason is that as real income grows in the United States, households and firms have more funds to spend and save. Accordingly, they will demand more U.S. goods, services, and securities. Thus, as U.S. real income grows, ceteris paribus, the supply of dollars will increase because Americans now have more income to spend on imports. Likewise, as U.S. real income falls, ceteris paribus, the supply of dollars will decrease.
2. Changes in the dollar price of U.S. goods relative to the dollar price of foreign goods. Simply put, if the prices of U.S. goods rise relative to the dollar prices of foreign goods, ceteris paribus, U.S. residents will demand more foreign goods and therefore supply more dollars in the foreign exchange market because foreign goods are now relatively cheaper than U.S. goods. Holding the exchange rate constant, what could cause such changes in relative prices? If you said a higher inflation rate in the United States falls relative to Japan, U.S. residents will supply fewer dollars in the foreign exchange market, ceteris paribus.
3. Changes in foreign interest rates relative to U.S. interest rates. As foreign interest rates rise relative to U.S. rates, ceteris paribus, foreign securities become relatively more attractive. Accordingly, U.S. residents will buy more foreign securities and thus, supply more dollars. Likewise if foreign rates fall relative to U.S. rates the supply of dollars decreases, ceteris paribus. To be more precise, U.S. residents will compare interest rates in the United States, with the expected return on foreign securities. The latter consists of the foreign interest rate, minus the expected appreciation (if any) in the value of the dollar.

For a graphical presentation of this analytical discussion of supply, see Exhibit (1). 

1. Changes in the Exchange Rate: The Role of Changes in Supply

This exhibit begins with an initial equilibrium exchange rate of 100 yen. Assume that the equilibrium is now disturbed by a change in one of the factors that affect the supply of dollars, say, a rise in U.S. income, which increases the supply of dollars as shown by the rightward shift of the supply curve. The new equilibrium at point B results in a depreciation of the dollar, as the equilibrium exchange rate falls from 100 yen to 50 yen. Note that a rise in the prices of U.S. goods relative to the dollar prices of foreign goods, or a rise in foreign interest rates relative to U.S. interest rates, would have produced a similar increase in supply and depreciation of the exchange rate.

Using the same logic and analytical framework we used for supply, we now ask what factors, in addition to the exchange rate, could cause foreigners to alter their demand for U.S. goods, services, and securities and thus, their demand for dollars in the foreign exchange market. Remember that changes in the demand for dollars cause the demand curve for dollars to shift. We begin by identifying the major factors that can alter demand: 

1. Changes in foreign real income. Ceteris paribus, changes in foreign real income and the demand for dollars are positively related. For example, if foreign real incomes rise, ceteris paribus, foreign firms and households will have more funds to spend and save. Accordingly, they will demand more of their own goods, services, and securities. Thus, as foreign real incomes grow, ceteris paribus, the demand for dollars, reflecting the increased supply of yen to execute transactions will grow. Following similarly reasoning, if foreign incomes fall, the demand for dollars will also fall, ceteris paribus.
2. Changes in the foreign (yen) price of foreign goods relative to the foreign price of U.S. goods. Ceteris paribus, changes, in say, the yen price of Japanese goods relative to the yen price of U.S. goods and the demand for dollars are positively related. To see why, assume inflation accelerates in Japan, while there is no inflation in the United States. The Japanese inflation will raise the yen price of Japanese goods relative to the yen price of U.S. goods. As a result, foreigners will demand more U.S. and thus more dollars, ceteris paribus. If U.S. inflation rises relative to inflation in Japan, foreigners will demand fewer dollars, ceteris paribus.
3. Changes in U.S. interest rates relative to foreign interest rates. A positive relationship also exists between changes in U.S. interest rates relative to foreign rates and the demand for dollars. For example, suppose that initially the interest rate on both foreign government bonds and U.S. Treasury bonds is 6 percent. Portfolio managers in Japan, noticing the identical rates and recognizing the benefits of diversification, hold some of both types of bonds in their portfolios. Now interest rates in the United States rise. As a result, the demand for U.S. securities and thus, the demand for dollars rise, ceteris paribus. Likewise, if interest rates in Japan fall, the demand for dollars rises, ceteris paribus.

2. Changes in the Exchange Rate: The Role of Changes in Demand

Assume that the initial equilibrium at point A is disturbed by a change in one of the factors that affect the demand for dollars. In particular, suppose that the yen price of U.S. goods rises relative to the yen price of foreign goods because of inflation in the United States. As a result, foreigners' demand for U.S. goods declines, as shown by the leftward shift of the demand curve. The new equilibrium (point B) results in a depreciation of the dollar from 100 yen to 50 yen. Note that a fall in foreign incomes or a rise in foreign interest rates relative to U.S. rates would have produced a similar leftward shift in the demand curve and depreciation of the dollar.

These points are illustrated graphically in exhibit (2). Note the similarities between the factors that cause changes in the demand for dollars, and the factors that cause changes in the demand for dollars, and the factors that cause changes in the supply of dollars.

Recap

Increases in real income, in U.S. prices, and in foreign interest rates, relative to U.S. interest rates, all increase the supply of dollars, and vice versa. Increases in foreign real income, in foreign prices relative to U.S. prices, and in U.S. interest rates native to foreign interest rates all increase the demand for dollars, and vice versa.

*SOURCE: THE  FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 202-205*

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