Relative to other countries.
*Units of foreign currency per dollar: indicates domestic currency appreciation; , depreciation.
Note: Only increases ( ) in the factors are shown; the effects of decreases in the variables on the
Chapter 15 The Foreign Exchange Market
353
assets denominated in the foreign currency). Because the exchange rate is the
price of one asset in terms of another, the natural way to investigate the short-
run determination of exchange rates is to use an asset market approach that
relies heavily on our analysis of the determinants of asset demand developed in
Chapter 4. As you will see, however, the long-run determinants of the exchange
rate we have just outlined also play an important role in the short-run asset mar-
ket approach.
3
In the past, supply-and-demand approaches to exchange rate determination
emphasized the role of import and export demand.
The more modern asset market
approach used here emphasizes stocks of assets rather than the flows of exports
and imports over short periods, because export and import transactions are small rel-
ative to the amount of domestic and foreign assets at any given time. For example,
foreign exchange transactions in the United States each year are well over 25 times
greater than the amount of U.S. exports and imports. Thus, over short periods, deci-
sions to hold domestic or foreign assets play a much greater role in exchange rate
determination than the demand for exports and imports does.
Supply Curve for Domestic Assets
We start by discussing the supply curve. In this analysis we treat the United States
as the home country, so domestic assets are denominated in dollars. For simplicity,
we use euros to stand for any foreign country’s currency, so foreign assets are denom-
inated in euros.
The quantity of dollar assets supplied is primarily the quantity of bank deposits,
bonds, and equities in the United States, and for all practical purposes we can take
this amount as fixed with respect to the exchange rate. The quantity supplied at
any exchange rate does not change, so the supply curve, S, is vertical, as shown in
Figure 15.3.
Demand Curve for Domestic Assets
The demand curve traces out the quantity demanded at each current exchange rate
by holding everything else constant, particularly the expected future value of the
exchange rate. We write the current exchange rate (the spot exchange rate) as E
t
,
and the expected exchange rate for the next period as
. As the theory of asset
demand suggests, the most important determinant of the quantity of domestic (dol-
lar) assets demanded is the relative expected return of domestic assets. Let’s see
what happens as the current exchange rate E
t
falls.
Suppose we start at point A in Figure 15.3 where the current exchange rate is
at E
2
. With the future expected value of the exchange rate held constant at
, a
lower value of the exchange rate, say at E*, implies that the dollar is more likely to
rise in value, that is, appreciate. The greater expected rise (appreciation) of the
dollar, the higher the relative expected return on dollar (domestic) assets. The the-
ory of asset demand then tells us that because dollar assets are now more desirable
to hold, the quantity of dollar assets demanded will rise, as is shown by point B in
Figure 15.3. If the current exchange rate is even lower at E
1
, there is an even higher
E
t
⫹1
E
E
t
⫹1
E
3
For a further description of the modern asset market approach to exchange rate determination that
we use here, see Paul Krugman and Maurice Obstfeld,
International Economics, 8th ed. (Boston:
Pearson Addison Wesley, 2009).
354
Part 5 Financial Markets
expected appreciation of the dollar, a higher expected return, and therefore an even
greater quantity of dollar assets demanded. This is shown in point C in Figure 15.3.
The resulting demand curve, D, which connects these points, is downward-sloping,
indicating that at lower current values of the dollar (everything else equal), the quan-
tity demanded of dollar assets is higher.
Equilibrium in the Foreign Exchange Market
As in the usual supply-and-demand analysis, the market is in equilibrium when
the quantity of dollar assets demanded equals the quantity supplied. In Figure 15.3,
equilibrium occurs at point B, the intersection of the demand and supply curves.
At point B, the exchange rate is E*.
Suppose that the exchange rate is at E
2
, which is higher than the equilibrium
exchange
rate of E*. As we can see in Figure 15.3, the quantity of dollar assets sup-
plied is then greater than the quantity demanded, a condition of excess supply. Given
that more people want to sell dollar assets than want to buy them, the value of the
dollar will fall. As long as the exchange rate remains above the equilibrium exchange
rate, there will continue to be an excess supply of dollar assets, and the dollar will fall
in value until it reaches the equilibrium exchange rate of E*.
Similarly, if the exchange rate is less than the equilibrium exchange rate at E
1
,
the quantity of dollar assets demanded will
exceed the quantity supplied, a condition
of excess demand. Given that more people want to buy dollar assets than want to sell
them, the value of the dollar will rise until the excess demand disappears and the
value of the dollar is again at the equilibrium exchange rate of E*.
S
Exchange Rate, E
t
(euros/$)
1.05
Quantity of Dollar Assets
E
*
= 1.00
0.95
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