Changes in the Supply of u.S. Dollars
A change in any relevant factor other than the exchange rate changes the supply of dollars and shifts the supply curve of dollars.
U.S. Demand for Imports: An increase in the U.S. demand for imports increases the supply of U.S. dollars because U.S. importers offer U.S. dollars in order to buy the foreign currency necessary to pay foreign producers. The supply curve of U.S. dollars shifts rightward.
U.S. Interest Rate Differential: The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the smaller is the supply of U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the supply curve for U.S. dollars leftward.
Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the supply of U.S. dollars decreases and the supply curve shifts leftward.
Changes
in the Exchange Rate
The exchange rate changes when the demand for and/or the supply of foreign exchange change.
When the expected future U.S. exchange rate increases, the demand for U.S. dollars increases and the supply decreases. As the figure shows, the demand curve shifts rightward, from D0 to D1, and the supply curve shifts leftward, from S0 to S1. The exchange rate rises, and quantity traded does not change by much, indeed in the figure it does not change at all.
Exchange Rate Expectations
Exchange rate expectations depend on deeper economic forces that influence the value of money:
Interest Rate Parity: Interest rate parity, which means equal rates of return, is the idea that the real interest on equally risky assets is the same in different countries. Adjusted for risk, interest rate parity always prevails. Market forces achieve interest rate parity very quickly.
Purchasing Power Parity: Purchasing power parity, which means equal value of money, is the idea that, at a given exchange rate, goods and services should cost the same amount in different countries. Purchasing power parity is an important force affecting prices and exchange rates in the long run and influences exchange rate expectations.
The exchange rate market responds instantly to news about changes in the factors that influence the demand and supply in the foreign exchange market.
The Real Exchange Rate
The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. It tells how many units of a foreign currency one U.S. dollar buys. The real exchange rate is the relative price of U.S-produced goods and services to foreign-produced goods and services. It tells how many units of foreign GDP one unit of U.S. GDP buys. The real exchange rate, RER, is equal to
RER = (E P)/P*
where E is the nominal exchange rate, P is the U.S. price level, and P* is the foreign price level.
The Nominal and Real Exchange Rates in the Short Run and in the Long Run
Nominal and real exchange rates are linked by the equation RER = E (P/P*).
Short Run: In the short run, this equation determines the real exchange rate. The nominal exchange rate is determined in the foreign exchange market by the supply and demand for dollars. Price levels do not change rapidly and so any change in the nominal exchange rate translates into a change in the real exchange rate.
Long Run: In the long run, rewrite the equation as E = RER (P*/P). In the long run, the real exchange rate is determined by the supply and demand for imports and exports and the price level in each nation is determined by the quantity of money in that nation. So in the long run, a change in the quantity of money changes the price level and thereby changes the nominal exchange rate