Question

Explain three reasons why a currency would appreciate relative to another currency. Use real world examples to help answer the question.

Answer 1

Following are three reasons why a currency would appreciate relative to another currency:

1) Increase in export: If the demand for domestic goods increases in the foreign country, the demand for the domestic currency will increase and it will appreciate, holding all else constant. For example, if the demand for US goods increases in Europe, the demand for the dollar will increase in Europe and the dollar would appreciate with respect to the euro.

2) Fall in the supply of domestic currency: If there is a contractionary monetary policy and as a result, the supply of domestic currency falls, it will result in the appreciation of the domestic currency. For example, if the US Fed reduces the supply of dollar, it will result in an appreciation of the dollar with respect to another currency for say yen.

3) A rise in the interest rate of the domestic currency: If the interest rate of the domestic currency increases, this will result in the appreciation of the domestic currency. For example, if the interest rate of the dollar increases with respect to the interest rate on euro, the dollar will appreciate because of its higher demand.