Exchange Rates: Equilibrium: Study with Video Lessons, Practice Problems & Examples

In the foreign exchange market, the equilibrium exchange rate is determined by the supply and demand for US dollars. A high value of the US dollar leads to lower demand for exports and foreign investments, while a low value increases demand. The demand curve slopes downward, reflecting that as the price of US dollars rises, demand decreases. Conversely, the supply curve slopes upward, indicating that a stronger dollar results in more imports and investments. The intersection of these curves establishes the equilibrium rate, influencing currency appreciation and depreciation.

Exchange Rates on the Graph

So, would it be economics if we didn't go ahead and throw it on the graph? Let's go ahead and see the equilibrium in the exchange rate market. So when we think about Exchange Rates, we're going to have the supply and demand for a currency, right? The supply of US dollars traded for a foreign currency and the demand for those US dollars by foreigners, right? The quantity of US dollars demanded and we're thinking about foreigners here. The foreign demand for US dollars, well guess what? We're still going to have our downward demand, our double d's. This downward demand, it's been pretty consistent throughout the course and it follows through here. We've got our quantity of US dollars demanded, it's going to have this downward demand. And why is that? When the value of the US dollar is high, there's a high US dollar value, we're going to have less exports which means less demand because when the US dollar value is high, it makes those US goods more expensive for a foreigner because the US dollar is more valuable. It's going to cost them more to get US dollars and there's going to be less demand for US goods. Okay? And there's going to be less foreign demand for US investments because of the same thing. If they wanted to buy a US investment, well it's going to cost them more of their currency. So, less demand here as well. The opposite when the value of a US dollar is low. Now US dollars are cheap to buy. Well, there's going to be more exports leading to more demand for US dollars and this is for US dollars. And the same thing with demand for US investments now. Now that they can buy US dollars cheaper, they can buy these investments for cheaper. So there's going to be more demand for US dollars to buy these cheaper investments when the dollar is weak in that case, when there's a low value for the US dollar, well, foreigners are going to buy up those cheap dollars to buy exports and foreign demand, excuse me, US investments as well. Now, that's the downward demand, right? Because high US dollar value, lower demand. Low US dollar value, more demand, right? That's that opposite effect that we've learned with demand. Whenever the price goes up, the demand goes down. The price goes down, the demand goes up, right? That's that downward demand. So if we look on our graph, guess what our demand curve is going to look like? It's going to be the downward demand. So this is the demand curve for US dollars, right? Demand for US dollars there, for foreign currency. And just so you know, this is going to be the quantity of US dollars and this is going to be the exchange rate. Let's say we're talking about, Great British Pounds per US dollar. Great British Pounds per US dollar, okay? So it's the exchange rate on that axis and we've got the quantity of US dollars on this axis down here, okay? So that's the demand for US dollars. Now, let's look at the supply. The quantity of US dollars supplied in this foreign exchange market. Well, a high-value US dollar, when dollars are worth a lot, means we can buy more stuff from foreign countries. More imports, right? So that's going to be more supply, right? We're supplying our dollars to buy these imports. So there's more supply of dollars and there's going to be more demand for foreign investments because we have this strong dollar, we can buy these foreign investments for cheaper. So more supply of US dollars, we're going to be exchanging these US dollars to buy these foreign investments. A low US dollar, well, it's the opposite effect, right? There's less supply because we have fewer imports. We're not going to be buying as much stuff overseas because it's going to be more expensive. And less supply as well for the same logic for foreign investments, right? With a weak dollar, it's going to cost us more to buy foreign investments, so we're not going to supply those dollars in that market anymore. So notice what we have here. High-value US dollar, more supply. Low-value US dollar, low supply. Just like we're used to with supply as well. So supply is going to have this upward slope like we're used to. And look at this graph. Doesn't it look familiar to us? It's our standard X-shaped graph and guess where our equilibrium is. Our equilibrium is here, right in the middle where the two lines cross. So this is the supply of US dollars. And there we go. That's what we have here. So this is going to be our equilibrium exchange rate. So this is our equilibrium rate. I'll say, r star right there, and then our equilibrium quantity exchange. So that'll be the quantity of dollars exchanged right there. Okay? So that's about it. That's our equilibrium in the market. We're going to get into how we shift these curves as well. One thing I want to note is sometimes you see a situation where the supply, they actually treat it as fixed and they'll have this straight upward supply in this market. Well, we end up having very similar results because our focus here is on the exchange rate. So when we start shifting these curves, our focus is on what's going to happen in the exchange rate. Is it going to go up or down? Does the currency appreciate, depreciate? So, we end up with the same results regardless of if we have this upward supply or the straight up and down supply. So you can double-check in your textbook, double-check with your teacher. I'm going to use this because it's just what we're more familiar with, and it'll get us the same results. But if you're going to be having to draw these curves, double-check with your professor if you're going to have to draw the curves and make sure you do it their way. Okay? Either way, like I said, we'll end up with the same results here when we're analyzing the graph. Cool? Let's go ahead and pause and we'll move on to the next step.

Here’s what students ask on this topic:

What determines the equilibrium exchange rate in the foreign exchange market?

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.

How does a high value of the US dollar affect exports and foreign investments?

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.

Why does the demand curve for US dollars slope downward?

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.

What happens to the supply of US dollars when the dollar is strong?

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.

How do shifts in the supply and demand curves affect the equilibrium exchange rate?

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.