Economics 504 (2024)

Chapter 15 Outline

VIII. EXCHANGE RATES AND THEIR DETERMINATION

A. The Importance of Demand and Supply

1. An exchange rate is the number of units of one currency exchangeable for one unit of another.

2. The United States now uses a system of flexible or floating exchange rates.

3. Under this system, exchange rates are determined by the demand for and the supply of dollars.

a. The demand for dollars is based on other countries' desires to purchase our domestic goods and services and to invest in this country.

b. The supply of dollars is based on U.S. citizens' desires to purchase thegoods and services from other countries.

c. The equilibrium exchange rate occurs where the quantity of dollars demanded equals the quantity of dollars supplied.

4. If the exchange rate is not at its equilibrium level, there is a tendency for it to move towards the equilibrium rate.

a. If the quantity of dollars supplied exceeds the quantity of dollarsdemanded, the exchange rate will fall (A depreciation of the dollaroccurs.).

b. If the quantity of dollars demanded exceeds the quantity of dollars supplied, the exchange rate will increase (An appreciation of the dollaroccurs.).

B. Exchange Rates and the International Price of Goods

1. Movements in exchange rates alter the international price of goods and services.

a. If the dollar depreciates (the exchange rate falls), the relative price of domestic goods and services falls while the relative price of foreign goods and services increases.

1. The change in relative prices will increase U.S. exports and decrease its imports.

b. If the dollar appreciates (the exchange rate increases), the relative priceof domestic goods and services increases while the relative price of foreign goods and services falls.

1. The change in relative prices will decrease U.S. exports and increase its imports.

C. Real GDP

1. One factor affecting exchange rates is real GDP.

a. Increases in real GDP in the United States will increase the supply ofdollars to foreign countries, causing the dollar to depreciate.

D. Inflation Rates

1. A second factor affecting exchange rates is the inflation rate.

a. An increase in the U.S. inflation rate will increase the supply of dollars to foreign countries and decrease the demand for dollars in foreign countries, causing the dollar to depreciate.

E. Interest Rates

1. A third factor affect exchange rate is the rate of interest.

a. An increase in U.S. interest rates will decrease the supply of dollars to foreign countries and increase the demand for dollars in foreign countries, causing the dollar to appreciate.