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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 145 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. 146 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 147 148 Chapter Seven: The Theory of Markets