The Economics of Foreign Exchange: The Determinants of Foreign Exchange Rates

The Determinants of Foreign Exchange Rates Remember that the demand for dollars by foreigners is generated by the desire and ability of foreigners to buy U.S. goods and services and to acquire real and financial assets denominated in dollars. These are the factors that determine the supply of dollars in foreign exchange markets. The foreign exchange rate of the dollar is likely to change in response to change in a variety of economic conditions that change the demand for or supply of dollars in foreign exchange markets. Six major influences on the demand for and supply of dollars are foreign demand for U.S. exports, U.S. demand for imports, real interest rates in the United States relative to those abroad, profitability of direct investment in U.S. businesses and real estate in relation to profitability of similar investments abroad, expectation of the dollar's future price in terms of foreign currency, and the price level in the United States relative to those in foreign nations. Foreign Demand for U.S. Exports If British importers sharply increase their demand for U.S. grain without decreasing their demand for other U.S. products, British demand for U.S. dollars will go up. The entire demand curve for dollars by British citizens will shift outward. Other things being equal, an increase in British demand for U.S. exports tends to put upward pressure on the exchange rate of the dollar in terms of British pounds. An increase in foreign demand for U.S. exports can result from increases in real income in foreign nations. Remember that income is a major-determinant of import demand (see the chapter on the components of aggregate demand). As income increases in a foreign nation, the annual dollar volume of imports from the United States tends to increase. An increase in real income in foreign nations will therefore tend to put upward pressure on the exchange rate of the dollar. A decrease in income in foreign nations that are customers for U.S. exports will tend to decrease the demand for U.S. dollars and put downward pressure on the price of the dollar. From 1985 to 1988, lagging income and high unemployment rates in many foreign nations were responsible for slack demand of U.S. dollars, which put downward pressure on the price of the dollar in terms of foreign currency. Similarly, changes in tastes can affect the demand for U.S. goods by foreigners. If U.S. products become more fashionable, the demand for U.S. dollars by foreigners will increase, putting upward pressure on the price of the dollar. The graph in Box 5 shows how an increase in the demand for dollars by German citizens resulting from an increase in German demand for U.S. exports will cause an increase in the exchange rate of the dollar. If the growth rate of real income in Germany exceeds that in the United States, the result is likely to be upward pressure on the exchange rate of the dollar, as shown in Box 5. U.S. Demand for Imports An increase in U.S. demand for imports will increase the supply of dollars offered in foreign exchange markets. For example, if U.S. demand for BMWs and Mercedes-Benzes increases along with the demand for other German products, the result will be an increase in the supply of dollars on the foreign exchange market. This will decrease the exchange rate of the dollar. The graph in Box 6 shows how an increase in the supply of dollars reduces the price of the dollar in terms of marks. A major factor influencing U.S. demand for imports is real income in the United States. An increase in aggregate real income tends to increase the U.S. demand for imports. As this occurs, the supply of dollars offered in foreign exchange markets increases, putting downward pressure on the price of the dollar. Similarly, a decrease in aggregate real income in the United States will decrease U.S. demand for imports. As the supply of dollars declines, there will be upward pressure on exchange rates.