Question

Using the supply and demand diagram for euros, explain verbally and demonstrate graphically the effect of each of the following scenarios on the exchange rate for euros: (1) An increase in income in Europe; (2) An increase in the price level in the U.S.; (3) A decrease in the interest rate in Europe.

Answer 1

In each graph, exchange rate (P) and quantity of Euro (A) are depicted along vertical and horizontal axes. D0 and S0 are initial demand and supply curves of Euro, intersecting at point A with initial exchange rate P0 and initial quantity of Euro Q0.

(1)

Higher income in Europe will increase Europe's import demand, thereby decreasing the demand for Euro and increasing the demand for foreign currency (to pay for higher imports). At the same time, supply of Euro will rise (since Europe will sell euro to buy foreign currency), shifting Euro supply curve rightward. This will appreciate foreign currency and depreciate Euro, decreasing exchange rate. In following graph, D0 will shift leftward to D1 and S0 will shift rightward to S1, intersecting at point B with lower exchange rate P1 and new quantity of Euro Q1.

(2)

Increase in US price level will make European goods cheaper in US compared to US domestically made goods, which will raise European export demand, raising the demand for Euro and lowering the demand for foreign currency (dollar), shifting demand curve for euro rightward. At the same time, supply of euro will fall, shifting supply curve leftward. This will depreciate Dollar and appreciate Euro, increasing exchange rate. In following graph, D0 will shift rightward to D1 and S0 will shift leftward to S1, intersecting at point B with higher exchange rate P1 and new quantity of Euro Q1.

(3)

Lower interest rate in Europe will decrease foreign investment in Europe, lowering the demand for Euro and increasing the demand for foreign currency. Demand curve for Euro will shift leftward, decreasing exchange rate. At the same time European investors will sell euro to purchase foreign currency, so supply of Euro will increase. Supply curve for Euro will shift rightward, lowering exchange rate. The net effect is a depreciation of Euro and decrease in exchange rate. In following graph, D0 shifts left to D1 and S0 shifts right to S1, intersecting at point B with lower exchange rate P1 and new quantity Q1.