Exchange Rates: Shifts in Supply and Demand: Study with Video Lessons, Practice Problems & Examples

Shifts in the supply and demand curves in the foreign exchange market impact the exchange rate equilibrium. An increase in foreign income or US interest rates raises demand for US dollars, leading to appreciation. Conversely, a decrease in these factors results in depreciation. Similarly, higher US income increases the supply of dollars for imports, lowering the exchange rate, while lower foreign interest rates decrease supply, causing appreciation. Understanding these dynamics is crucial for analyzing exchange rate fluctuations and their implications on international trade and investment.

Exchange Rates: Shifts in Demand

Now, let's see how shifts in the supply and demand curve affect the exchange rate market and what happens to our equilibrium. So like we saw, there's going to be an equilibrium in the exchange rate market, right? We have our X graph with our exchange rate equilibrium in the middle and then now what we're going to do is we're going to shift the demand or the supply to the left or the right and see where our new equilibrium exchange rate ends up. Okay? So we have our supply and demand just like we're used to. Let's start here with shifts in demand. So the shift in the quantity of US dollars demanded, and this is foreigners demanding US dollars. So remember, when we're going to shift the curve, when we're shifting the demand curve, it would be because some sort of determinant, some sort of underlying factor to demand has changed from where it was before. Okay? So we'll have our where our demand was and then something has changed that's going to have shifted to the left or right. The first thing could be a change in the foreign country's income. So let's say the foreigners are making more income now. Well, if there's more foreign income, well, they're going to want to import more stuff. They're going to have more money available and they're going to want to buy more things. So there's going to be more demand for the US dollar. Okay? So more foreign income that leads to a shift to the right. If they have less foreign income, if they're making less money, well, they are not gonna be able to afford US goods and they will not demand the US dollars. So we'll have the opposite. If there's a change in US interest rates, well, now think about US interest rates as investments. So if there's higher interest rates in the US, that means people would want to invest in US investments to get that higher interest, right? So when the US interest rates go up, there's more demand for US dollars to buy US investments and get these higher interest rates. So that would shift it to the right as well and that's when there's a change in the interest rate. The third thing is a change in speculative outlook. So when we talk about speculation, this is people just expecting things to happen. This is more almost like gambling, but like gambling on what you expect to happen in the future. So they're making expectations of rate changes in the future. So if you think these speculators, people who are looking into the market and doing analysis and saying, I think in the future, the US dollar is going to appreciate in value. Well, that means people are going to demand more dollars right now, right? They're going to want those dollars now so that they'll be stronger in the future. They'll hold the dollars and they'll appreciate in the future and be worth more money. So these speculators would make money on this investment here by getting the US dollars now. So we can have good things or bad things, right? We discussed in these examples all the good things that can happen that would affect demand, right? More foreign income, higher interest rates, expected appreciation but the opposite could happen as well, right? Less income, lower interest rates and the opposite effect would happen. So just like when we talked about shifting demand in other cases, we have what's the good shifts which are shifts to the right. Good for demand and then bad for demand, right? Things that are going to shifted to the left. So let's start here and let's do our good shift and we'll have our original graph. We'll do our original in blue where we're gonna have our downward demand, upward supply. And remember, this will be we'll say Great British pounds to US dollars. This will be our exchange rate, the price of these US Dollars in this market and then the quantity of US Dollars down here. Okay? So if this was our original equilibrium here and something good happened to demand, say there was higher interest rates in the US leading to higher demand for US dollars, well, we would shift to the right. We would shift to the right and we would end up in a situation like this. So that was our original equilibrium and now our new equilibrium. So our original equilibrium, we'll say was rate 1 and this quantity, quantity 1. Now, what I want to say is we generally focus on what happens to the exchange rates in these. So we want to see did the exchange rate go up or down when we had this shift to the right of demand. So now we're at demand 2 here. Well, we have this higher exchange rate, right? And what does that mean? That means there's more Great British Pounds per dollar. So if this was 1.5 to $1, so 1.1.5, pounds per dollar, now we're at say £1.7 per $1, okay? 1.7 to $1. It went up, the rate went up in that situation, right? So each dollar can get more pounds. The dollar has appreciated when the demand goes up, right? The price goes up in that sense. Cool? How about the other situation when we have a bad example here? When, let's say now, we have foreign income decrease. So there's less exports and there's less demand for US dollars. We'll have the same thing where we start with our original situation. We've got our supply, our demand. And now, we have a decrease in demand and we have our new equilibrium down here, right? So where our original equilibrium here was R1, well, now we've decreased our equilibrium. Not that much. We've decreased right here to R2. So this is the opposite situation. If we had started let me get out of the way. So if we had started here at our original equilibrium, let's say was, 1.5 to 1 like we said before, pounds to dollars. Well now let me do it in a different color so it stands out. So this was a situation where we were like £1.5 for $1. Well, now we're at say £1.3 for $1. The dollar's gotten weaker. Right? We're getting £1 per dollar in this situation. We go to the bank with $1 and we only get £1.3 where we used to get 1.5, right? Because the demand has weakened, so the price of those dollars has gone down, Okay? So that's kind of what we're used to except now the only thing that's different is this Y axis, right? Where we're thinking about the exchange rate on that Y axis. Okay? So let's go ahead and pause here and let's talk about shifts in supply.

Exchange Rates: Shifts in Supply

Alright. So let's continue here with the shifts in the supply in the exchange rate market. And notice how similar these are to what we talked about above. Except now we're talking about, say, US income. So let's look at these shifts in supply. The first one being a change in US income. So before we talked about the change in foreign income demanding US dollars. Now it's the US income has increased, and we're going to buy foreign goods. So we're going to be supplying our dollars to buy foreign goods. So when there's more US income, there's more demand for imports and when we buy things with imports, we're supplying our dollars in the market and we're buying things, in we're buying things from other countries. So our dollars are being supplied to the market and then we're buying imports here. So there's more supply of US dollars in that foreign market, foreign exchange market there.

And the second, notice this is the opposite as well. Now, it's a change in foreign interest rates. So this again is US dollars being supplied. We're taking our dollars and we're paying to buy foreign investments. So when there's higher foreign interest rates, we want to buy those foreign investments to get that higher interest. So we supply our US dollars and we buy those foreign investments. So there's more supply of US dollars. And finally, just like before, there could be a change in the speculative outlook. So this one's the opposite as well. If there's an expected depreciation of US dollars, we would supply those dollars now, there would be more supply of US dollars now so that we could buy foreign investments expected depreciation of the US dollar, well, we have a decrease in the expected depreciation of the US dollar, well, we have a decrease in the supply. Excuse me, an increase in the supply there as well.

Okay, so again, we have the opposite effects too, right? If there's a decrease in US income, right? We would see the opposite effect, a lower supply, a decrease in foreign interest rates, right? So let's go ahead and just like before, let's see what happens on our graphs here when we have the good thing happened to supply and the bad thing happened to supply. So we'll start with our original situation which is just our standard X graph. And remember, this will be say Great British Pounds to US Dollars. And this will be the quantity here. So if this was our original demand and supply, and now we had something good happen to supply. Say, there was higher US income, so we're demanding more imports. We're supplying these dollars to the market. Well, the supply is going to shift to the right and we're going to be in this new situation. So what happens to the exchange rate here? For the exchange rate was originally here at r one, well, it's decreased, right? We see a decrease in the exchange rate. So if this was, say, £1.5 for $1, now we're at 1.3. Right? It decreased £1.3 for $1 Okay? So it decreases there when supply increases. So that's always what you want to be able to do is figure out which way the curve shifts and then analyze the new situation. And notice how we're focused mainly just on the exchange rate. We're not focused here on the quantity as much. This is the big focus of this unit is what's happening over here.

And now the opposite, a bad thing happening for supply here. So this would be a situation where, say the US interest rates, or excuse me, the foreign interest rates have gone down, right? Foreign interest rates have decreased so there's less investment, right? And that's the opposite of what we see here. When foreign interest rates went up, we were supplying more dollars. Well, if foreign interest rates go down, we're going to supply less dollars. Okay? So we have our original situation, supply and demand. And now we're going to shift the supply to the left and we'll be at supply 2. So where's our new equilibrium? Right there where our original rate was there and now our rate has gone up. Right? Our rate has gone up to r2 there. So this would be the opposite situation. Maybe we started at £1.5 per $1 and now we're at £1.7 per $1. Okay? So this is very similar to what we've done before shifting graphs left and right. Now we're just thinking of it in the exchange rate market. Okay? So just remember those determinants there that we were dealing with, with foreign income, with the interest rates and speculation, alright? So that's about it here. Let's go ahead and pause and we'll move on to the next video.

Here’s what students ask on this topic:

What factors cause shifts in the demand curve for US dollars in the foreign exchange market?

Several factors can cause shifts in the demand curve for US dollars in the foreign exchange market. These include changes in foreign income, US interest rates, and speculative outlooks. For instance, an increase in foreign income leads to higher demand for US goods, thus increasing the demand for US dollars. Higher US interest rates attract foreign investments, also raising the demand for US dollars. Speculative outlooks, where investors expect the US dollar to appreciate, can lead to increased demand as investors buy dollars now to benefit from future gains. Conversely, decreases in these factors can shift the demand curve to the left, reducing the demand for US dollars.

How do changes in US interest rates affect the exchange rate of the US dollar?

Changes in US interest rates significantly impact the exchange rate of the US dollar. When US interest rates increase, they attract foreign investors seeking higher returns on investments. This increased demand for US investments leads to a higher demand for US dollars, causing the dollar to appreciate. Conversely, when US interest rates decrease, the demand for US investments falls, leading to a lower demand for US dollars and causing the dollar to depreciate. Thus, higher interest rates generally lead to an appreciation of the US dollar, while lower interest rates result in depreciation.

What happens to the exchange rate when there is an increase in US income?

An increase in US income typically leads to a higher demand for foreign goods and services. As Americans buy more imports, they supply more US dollars in the foreign exchange market to pay for these goods. This increase in the supply of US dollars leads to a depreciation of the US dollar. In other words, the exchange rate decreases, meaning that each US dollar can buy fewer units of foreign currency. This shift in supply causes the equilibrium exchange rate to move to a lower level.

How does a change in foreign interest rates influence the supply of US dollars?

A change in foreign interest rates can significantly influence the supply of US dollars. When foreign interest rates increase, US investors are more likely to invest in foreign assets to gain higher returns. This leads to an increased supply of US dollars in the foreign exchange market as investors exchange dollars for foreign currency. Conversely, when foreign interest rates decrease, US investors are less inclined to invest abroad, reducing the supply of US dollars. Therefore, higher foreign interest rates increase the supply of US dollars, while lower foreign interest rates decrease it.

What is the impact of speculative outlooks on the exchange rate of the US dollar?

Speculative outlooks can have a significant impact on the exchange rate of the US dollar. If investors expect the US dollar to appreciate in the future, they will demand more US dollars now to benefit from the anticipated increase in value. This increased demand leads to an appreciation of the US dollar. Conversely, if investors expect the US dollar to depreciate, they will supply more US dollars now to avoid potential losses, leading to a depreciation of the dollar. Thus, positive speculative outlooks can cause the dollar to appreciate, while negative outlooks can lead to depreciation.