Predict Changes in the Euro–Dollar Exchange Rate
The demand–supply model predicts that the higher-inflation country’s currency will depreciate. Continuing with the U.S. and the Euro-zone example, if the U.S. has a higher inflation rate than that of the Euro-zone, the dollar is expected to depreciate against the euro.
When you work with the demand–supply model of exchange rate determination, first think about whether the relevant factor is related to trade or portfolio flows. Second, think about the people represented by the demand and supply curve and what they would do, given the nature of the change in one of the macroeconomic fundamentals.
Remember that inflation rate is a trade-related variable. If the U.S. inflation rate is higher than that of the Euro-zone, at the given exchange rate, European goods become less expensive to American consumers. Therefore, Americans are inclined to sell their dollars, buy euros, and buy European goods. This increases the supply of dollars in the market.
However, at the given exchange rate, American goods become more expensive to European consumers because of higher inflation rates in the U.S. Therefore, European consumers are now less inclined to buy American goods. Their demand for dollars decreases.
The figure shows that the dollar depreciates (and the euro appreciates) when the U.S. runs a higher inflation rate than the Euro-zone.
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).
Remember, interest rate is a portfolio flow–related factor. Think of yourself as an investor who is deciding between a dollar- and a euro-denominated investment opportunity (with the same risk). Because the main subject is portfolio investment, the interest rate considered here is the real interest rate.
The real interest rate is defined as the difference between the nominal interest rate and the inflation rate.
This model predicts that the currency of the country with the higher real interest rate will appreciate. As an investor, and at the given exchange rate, you decide to invest in a security that gives you a higher real return. Suppose that the Euro-zone’s real interest rates are higher. The figure shows the implications of this change on the euro–dollar exchange rate.
When you look at the demand and supply curve, identify the investors along these curves. As the real interest rate on Euro-denominated securities increases, investors’ demand for dollar-denominated securities declines. Therefore, the demand for the dollar declines. In terms of the supply of dollars, investors are inclined to sell their dollars in exchange for euros to buy euro-denominated securities.
The supply curve for dollars increases. Both an increase in the supply curve and a decrease in the demand curve lead to the appreciation of the euro (or the depreciation of the dollar).
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).