Predict Changes in the Euro–Dollar Exchange Rate
Assuming that trade and portfolio flows aren’t restricted, domestic consumers and investors have a choice of which country’s goods to consume and which country’s currency to invest in. However, governments may be concerned about this freedom and may not like domestic consumers’ and investors’ demand for foreign goods or portfolios.
The previous exercises in this chapter explain why governments may feel this way. Favoring foreign goods and portfolios implies the exchange of the domestic currency for foreign currency, which depreciates the domestic currency. Therefore, sometimes governments implement restrictions on trade or portfolio flows to prevent the domestic currency from further depreciation. These restrictions are expected to appreciate the restriction-imposing country’s currency.
Suppose that the U.S. starts imposing tariffs on some of the European Union’s (EU) imports. To keep the exercise simple, assume that the EU doesn’t retaliate.
The figure shows that trade restrictions imposed by the U.S. lead to a decline in the supply of dollars. The reason is that trade restrictions are prompting U.S. consumers to exchange fewer dollars for euros. The result is the appreciation of the dollar (or the depreciation of the euro).
The figure also illustrates government restrictions on capital flows. If the U.S. imposes restrictions on portfolio outflows, U.S. investors exchange fewer dollars for euros to put in a euro-denominated deposit. Therefore, the supply of dollars declines, and the dollar appreciates (and the euro depreciates).