Predict Changes in the Euro–Dollar Exchange Rate
Economic growth refers to an increase in a country’s output, or real gross domestic product (real GDP). The demand–supply model predicts that the higher growth rate country’s currency will depreciate. For example, if the Euro-zone’s real GDP growth rate is higher than that of the U.S., this model predicts that the euro will depreciate.
All other predictions of the demand–supply model are consistent with the monetary approach to exchange rates. Growth rate of real GDP is the only factor about which different theories provide different predictions.
For simplicity, assume that the U.S. growth rate shows no change and the Euro-zone’s growth rate increases. Again, remember that growth rate is a trade-related variable. If the Euro-zone’s growth rate is higher, then at the given exchange rate, Euro-zone’s consumers and businesses are expected to buy more consumption and investment goods from the U.S.
Therefore, Europeans are inclined to sell their euros, buy dollars, and buy American goods. This increases the demand for dollars and the price of dollars, which leads to the appreciation of the dollar (or the depreciation of the euro).