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 measured vertically and horizontally respectively. 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)

Increase in income in Europe will increase European import demand, which will decrease the demand for Euro and increase the demand for foreign currency. This will appreciate foreign currency and depreciate Euro, lowering exchange rate. Graphically, demand curve for Euro will shift leftward to D1, intersecting S0 at point B with lower exchange rate P1 and lower quantity of Euro Q1.

(2)

Increase in US price level will make European goods cheaper in US, which will increase European export demand, increasing the demand for Euro and decreasing the demand for foreign currency (dollar). This will depreciate Dollar and appreciate Euro, increasing exchange rate. Graphically, demand curve for Euro will shift rightward to D1, intersecting S0 at point B with higher exchange rate P1 and higher quantity of Euro Q1.

(3)

When Europe's interest rate is lower than Foreign interest rate, foreign investment will increase in foreign countries and decrease in Europe, decreasing the demand for Euro and increasing the demand for foreign currency. Demand curve for Euro will shift leftward, decreasing exchange rate. Simultaneously, European investors will sell euro to buy foreign currency (for investing in foreign assets), so supply of Euro will rise. Supply curve for Euro will shift rightward, decreasing exchange rate. The net effect is a definite 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.