Exchange Rates: Equilibrium: Videos & Practice Problems

The equilibrium exchange rate in the foreign exchange market is determined by the intersection of the supply and demand curves for a currency. For the US dollar, the demand comes from foreigners who need dollars to buy US goods, services, and investments. The supply comes from US residents who need foreign currency to buy foreign goods, services, and investments. The demand curve slopes downward, indicating that as the price of US dollars rises, the demand decreases. Conversely, the supply curve slopes upward, showing that a stronger dollar results in more imports and investments. The point where these two curves intersect is the equilibrium exchange rate.

A high value of the US dollar makes US goods and services more expensive for foreigners, leading to a decrease in demand for US exports. Similarly, foreign investments in the US become more costly, reducing the demand for US investments by foreigners. This is because a stronger dollar means that foreigners need to spend more of their own currency to obtain US dollars, making US products and investments less attractive. Consequently, the demand for US dollars decreases when the dollar's value is high.

The demand curve for US dollars slopes downward because of the inverse relationship between the value of the US dollar and the quantity demanded. When the value of the US dollar is high, it becomes more expensive for foreigners to purchase US goods, services, and investments, leading to a decrease in demand. Conversely, when the value of the US dollar is low, it becomes cheaper for foreigners to buy US goods, services, and investments, increasing the demand. This inverse relationship is consistent with the general law of demand, where higher prices lead to lower demand and lower prices lead to higher demand.

When the US dollar is strong, the supply of US dollars in the foreign exchange market increases. A stronger dollar means that US residents can buy more foreign goods, services, and investments for the same amount of dollars, leading to an increase in imports and foreign investments. As a result, more US dollars are supplied in the market to exchange for foreign currencies. This upward slope of the supply curve reflects the direct relationship between the value of the US dollar and the quantity supplied.

Shifts in the supply and demand curves can lead to changes in the equilibrium exchange rate. If the demand for US dollars increases (shifts right), perhaps due to higher foreign interest in US goods or investments, the equilibrium exchange rate will rise, leading to an appreciation of the US dollar. Conversely, if the demand decreases (shifts left), the equilibrium exchange rate will fall, causing the dollar to depreciate. Similarly, if the supply of US dollars increases (shifts right), perhaps due to higher US imports, the equilibrium exchange rate will fall, leading to a depreciation of the dollar. If the supply decreases (shifts left), the equilibrium exchange rate will rise, causing the dollar to appreciate.