Macroeconomics
G. Exchange Rate Determination In a floating exchange rate system, the equilibrium exchange rate is determined where the quantity demanded of a currency is equal to its quantity supplied. Graphically, this isthepointofintersection between the demand and supply curves of a currency, which is the U.S. dollar in the graph below.
In this graph, point X represents the equilibrium exchange rate of theU.S.dollarrelativetotheEuro, whereby Q $ * represents the equilibrium quantity of U.S. dollars exchanged in the market, and ER₁ represents the equilibrium exchange rate of the U.S. dollar in terms of the Euro (e.g., €0.93 per USD). The foreign exchange market is in disequilibrium when there is a shortage or surplus of a currency. However, like all other markets we’ve seen so far, the exchange rate will adjust until equilibrium is restored. For instance, if atanexchangerateof$1=€0.93,U.S.dollarholderswanttosell$5million,butEuro holderswanttobuyonly$4million,thenthereisasurplusof$1million.Thissurplusputsadownward pressure on the price of the U.S. dollar (e.g., $1 = €0.8) until the quantity supplied is equal to the quantitydemandedbecausethedollarbecomescheaperforEuroholders,encouragingthemtodemand more of it. Changes in the Foreign Exchange Market Equilibrium Any changes in the demand for or supply of a currency due to factors explained in Sections E and F cause a change in the equilibrium quantity and price (exchange rate) of the currency. To identify changes in the supply of a currency, think of who holds this currency. For example,inthe foreignexchangemarketoftheU.S.dollar,thesupplyofthedollarisaffectedbythosewhoholdtheU.S. dollar, therefore, it is mainly influenced by what happens in the U.S.
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