Introduction to Finance

equilibrium exchange rate 
currency exchange rate where the 
supply and demand for a currency 
are in balance

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6.4 Factors that Aff ect Currency Exchange Rates
139
to supply larger quantities of euros as the dollar value of euros increase. The market, in our 
example, is in balance, or in “equilibrium,” when one euro is worth $1.09. This price refl ects 
the market-clearing price that equates the demand (D
1
) for euros relative to the supply (S
1
) 
of euros. 
Now, assume Americans increase their demand for goods and services from eurozone 
member countries such as Germany and France. These goods and services would be priced in 
euros. Americans will need to exchange their dollars for euros to pay for their purchases. The 
consequence is an increase or shift in demand for euros from D
1
to D
2
, as depicted in Graph B 
of Figure 6.1. The supply of euros refl ects demand by eurozone member countries for U.S. 
goods and services, and as long as there is no change, S
1
will remain unchanged. As a con-
sequence of this scenario, the increased demand for euros results in a new higher equilibrium 
price of $1.10.
A further increase in the demand for the goods and services provided by eurozone mem-
ber countries could cause the dollar price or value of one euro to increase even more. Graph C 
in Figure 6.1 depicts such an increase as a shift from D
2
to D
3
. Again, with no change in the 
supply of euros, the new market-clearing price of a euro might be $1.11. Of course, as the 
euro’s dollar value increases, the prices of eurozone member goods also increase. At some 
point, as eurozone member goods become more costly, U.S. demand for these foreign goods 
will decline. Graph D depicts this cutback in U.S. demand for euros as a shift downward from 
D
3
in Graph C to D
2.
In a similar fashion, the higher dollar value of the euro in Graph C makes 
U.S. goods and services less costly to eurozone members, and thus the supply of euros might 
increase or shift from S
1
to S
2
. The net result could be a new equilibrium exchange rate in 
which the dollar price of a euro is $1.09.
A change in the demand for one country’s fi nancial assets relative to another country’s 
fi nancial assets also will cause the currency exchange rate between the two countries to change 
to a new equilibrium price. For example, a nation with a relatively strong stock market will 
attract investors who seek out the highest returns on their investment funds, much as a nation 
with a higher relative economic growth rate attracts capital investments. For example, if the 
stock market in the United States is expected to perform poorly relative to the stock markets 
in eurozone member countries, investors will switch or move their debt investments denomi-
nated in U.S. dollars into euro-denominated debt investments. This increased demand for 
euros relative to U.S. dollars will cause the euro’s dollar value to increase.
$1.09
S
1
D
1
Dollar Price
of One
Euro (€)
Quantity of Euros
Graph A
$1.10
S
1
D
2
D
1
Dollar Price
of One
Euro (€)
Quantity of Euros
Graph B
$1.11
S
1
D
1
D
2
D
3
Dollar Price
of One
Euro (€)
Quantity of Euros
Graph C
$1.09
S
2
S
1
D
2
Dollar Price
of One
Euro (€)
Quantity of Euros
Graph D