Money, Banking, and International Finance
Exchange rate fluctuations alter prices of all goods, services, and assets that businesses,
people, and government trade on the international markets. Analysts use appreciation and
depreciation to compare two currencies. As one currency appreciates, the other must depreciate
because these terms are relative to one another. When analysts refer to a weak or strong U.S.
dollar, analysts compare the U.S. dollar to a basket of currencies from industrialized countries.
A weak U.S. dollar means the value of the dollar decreased relative to a basket of other
currencies, such as the British pound, euro, and Japanese yen. A strong U.S. dollar is the
opposite.
Factors that Shift Demand and Supply Functions
Many factors influence supply and demand functions for foreign exchange rates. Several
factors include interest rates, inflation, income, and actions by central banks. For instance,
interest rates affect investment and financial capital inflows and outflows for a country, while
inflation affects a country’s prices and hence its trade flows. Inflation is a continual increase of
prices. Furthermore, a growing economy creates higher incomes, and greater demands for
normal goods, which are most products. Finally, central banks could influence exchange rates
by buying and selling currencies.
Real interest rate affects the currency exchange rates. Real interest rate means economists
subtracted the country’s inflation rate from the nominal interest rate. For example, we show the
Malaysian ringgit exchange market in Figure 4, and the original market price and quantity are
P and Q. If Malaysia has a greater real interest rate than the United States, then U.S. investors
increase their demand for ringgits; they want to earn the greater interest rate. Demand for
ringgits rises and shifts rightward. Furthermore, Malaysian citizens invest more within their
country, decreasing the supply of ringgits on the international markets. When the supply and
demand both shift, either the market quantity or price becomes indeterminate. In this case,
market price increases while market quantity becomes indeterminate. Consequently, the U.S.
dollar depreciates while the ringgit appreciates.
We can use a trick to determine which variable becomes indeterminate. First, shift the
demand function. Then draw three supply function shifts, where the first one shifts a little, the
second shifts a little more, and the third shifts a lot. Consequently, one variable always moves in
one direction while the other can increase and decrease, making it indeterminate.
Inflation rates of countries could impact the foreign exchange market. For example, Mexico
experiences a greater inflation than the United States. We depict the U.S. dollar exchange
market in Figure 5. Market price and quantity are P and Q. Higher inflation rate causes the
prices of Mexican goods to become expensive while prices for U.S. goods become relatively
cheaper. Therefore, Mexicans increase their demand for U.S. goods, increasing the demand for
U.S. dollars. On the other side of the border, the U.S. citizens buy more domestic goods,
decreasing their demand for Mexican goods. Hence, the supply for U.S. dollars decreases and
shifts leftward. Consequently, the U.S. dollar appreciates while the peso depreciates. In this
case, the equilibrium quantity for U.S. dollars becomes indeterminate.