Download Supply and Demand and the Value of the Dollar

Supply and Demand and the Value of the Dollar
Another everyday application of the supply-and-demand model is the determination of the
value of the dollar, or the exchange rate. Since the early 1970s, the international financial
system has operated on the basis of flexible exchange rates for currencies (see Chapter 21).
This means there is an international market with buyers and sellers for all of the different
currencies in the world. The prices of currencies are determined in these markets.
Currencies are used for international economic activities. For example, people in the United
States might want to buy products from Japan or invest in Japanese financial markets;
Applying Supply and Demand
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to do so, they have to exchange (supply) dollars for yen. Or people in Japan
might want to buy U.S. goods, invest in the U.S. stock market, or purchase
U.S. government treasury bonds; to do so, they have to exchange yen for
dollars (they would be purchasing, or demanding, dollars). There are
exchange markets because people all over the world want to buy goods and
services, make bank deposits, travel, or invest in other countries. In addition,
sometimes people want to protect the value of their assets by holding them in
a currency with an increasing value (and conversely getting out of currencies
with declining values).
As a result of changing supply and demand conditions in the foreignexchange markets, the value of currencies is constantly changing. Figure W
7.1 shows the number of Japanese yen that could be purchased for one U.S.
dollar from 2000 to 2007. As you can see, the value changes frequently.
These changes result from the changes in the determinants of exchange
rates. Table 8.4 summarizes how changes in the determinants of exchange
rates cause shifts in the supply and demand for dollars.
We can use supply-and-demand analysis to explain the increase in the
value (price) of the dollar in yen from January 2000 to April 2001. On January
3, 2000, 1 dollar was worth 102 Japanese yen (point a in Figure W 7.1).
However, the Japanese economy was mired in an economic slump at the
time, while the U.S. economy was booming. As a result, Japanese investors
decided to purchase greater amounts of U.S. stocks, bonds, and real estate.
Before they could do this, they had to use their Japanese yen to purchase
U.S. dollars, increasing the demand for U.S. dollars. As shown in Figure W
7.2, the increase in the demand for U.S. dollars shifts the demand curve from
D0 to D1, causing the price of the U.S. dollar to increase (appreciate) from 102
yen to 127 yen (the value the dollar reached on April 2, 2001; point b in Figure
W 7.1). The quantity of dollars exchanged increases from Q1 to Q2.
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Chapter Seven:
The Theory of Markets
TABLE 1 Shifts in the Supply and Demand for a Currency (such as U.S. Dollars)
Change in
Determinants of
Supply and Demand
Change in Supply
and Demand
Change in Price
of Dollars
(Exchange Rate)
Decrease in U.S. demand for
Supply of dollars decreases: U.S.
Price of dollars increases:
foreign goods, services, and assets
buyers spend less on foreign
Decrease in the supply of
dollars in foreign exchange
markets causes the dollar
to appreciate.
items, so they exchange fewer
dollars for foreign currency.
Increase in U.S. demand for foreign
Supply of dollars increases:
Price of dollars decreases:
goods, services, and assets
U.S. buyers spend more
on foreign items, so they
exchange more dollars
for foreign currency.
Increase in the supply of dollars
in foreign exchange markets
causes the dollar to depreciate.
Decrease in foreign demand for
Demand for dollars decreases:
Price of dollars decreases:
U.S. goods, services, and assets
Foreign buyers spend less
on U.S. items, so they
exchange less of their
currency for dollars.
Decrease in the demand
for dollars in foreign
exchange markets causes
the dollar to depreciate.
Increase in foreign demand for
Demand for dollars increases:
Price of dollars increases:
U.S. goods, services, and assets
Foreign buyers spend
more on U.S. items, so
they exchange more of
their currency for dollars.
Increase in the demand for
dollars in foreign exchange
markets causes the dollar
to appreciate.
FIGURE W
7.2
The Foreign Exchange Market for U.S. Dollars
Price
(Yen per
dollar)
S0
b
127
102
a
D1
D0
Q1 Q2
Quantity of
dollars
Applying Supply and Demand
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148
Chapter Seven:
The Theory of Markets