Question

Suppose we learn the news that suggests that the economy in Europe is likely to slump over the next 12 months. Use the model of supply and demand (and a brief explanation) to predict whether the Euro will appreciate or depreciate. Note: be complete in your explanation; it seems likely that more than one factor is at play in this supply and demand change.)

Answer 1

Suppose we learn the news that suggests that the economy in Europe is likely to slump over the next 12 months. Then, the foreign investors who have invested in Europe in the form of Foreign Domestic Investment (FDI) and Foreign Portfolio Investment (FPI) would begin to sell Europe's currency and convert it to their currency because if there is a slump over in the next 12 months, the foreign investors' would make huge losses on their investments. Further, the people who were trading in the currency market would also begin to sell Europe's currency because they can predict that with the foreign investors selling their assets the Euro would depreciate and with more people selling Euro and demanding other foreign currencies, the Euro would depreciate further.

Using the model of supply and demand, let's see how the Euro depreciates. Let's assume that we are comparing Euro with the US Dollars. The people who are holding the Euro are going to sell more of Euro and demand more of US Dollars when they are going to hear that there would be a slump in Europe. So, the supply of Euro would increase as shown by the diagram below. The SS was the original supply curve and after the increase in supply the new supply curve is S^'S^'. The people who have invested in Europe would begin to sell more Euro and demand their currencies, here since we have assumed the other currency is US Dollars so they would demand more of US Dollars. So, the demand for Euro would decrease than before and the demand curve DD would shift towards the left and the new demand curve is D^'D^'. We see from the graph that before the exchange rate was P_E and the equilibrium quantity was Q_E. But now, after the news the new exchange rate is P i.e. the Euro has depreciated and the equilibrium quantity is Q.