Starting with supply, let’s fi rst consider how and why changes in the supply of dollars in the foreign exchange market affect the exchange rate. The initial question that needs to be addressed is what factors, in addition to the exchange rate, could cause U.S. residents to alter their demand for foreign goods, ser vices, and securities, and thus their supply of
dollars in the foreign exchange market. In other words, what factors could cause the supply curve of dollars to shift? Previous research suggests that the following factors play a major role:
1. Changes in U.S. real income. Changes in U.S. real income and changes in the supply of dollars are positively related. The reason is that as real income grows in the United States, house holds and fi rms have more funds to spend and save. Accordingly, they will demand more U.S. goods, ser vices, and securities and more foreign goods, ser-vices, and securities. Thus, as U.S. real income grows, ceteris paribus, the supply of dollars will increase because Americans now have more income to spend on imports.
Likewise, as U.S. real income falls, ceteris paribus, the supply of dollars will decrease.
2. Changes in the dollar price of U.S. goods relative to the dollar price of foreign goods. Simply put, if the prices of U.S. goods rise relative to the dollar prices of foreign goods, cet-eris paribus, U.S. residents will demand more foreign goods and, therefore, supply more dollars in the foreign exchange market because foreign goods are now relatively cheaper than U.S. goods. Holding the exchange rate constant, what could cause such changes in relative prices? If you said a higher infl ation rate in the United States than in Japan, you are right! Likewise, using similar reasoning, if the infl ation rate in the United States falls relative to that in Japan, U.S. residents will supply fewer dollars in the foreign exchange market, ceteris paribus.
3. Changes in foreign interest rates relative to U.S. interest rates. As foreign interest rates rise relative to U.S. rates, ceteris paribus, foreign securities become relatively more attractive. Accordingly, U.S. residents will buy more foreign securities and, thus, supply more dollars. Likewise, if foreign rates fall relative to U.S. rates, the supply of dollars decreases, ceteris paribus. To be more precise, U.S. residents will com-pare interest rates in the United States, iUS, with the expected return on foreign securities. As we shall see later in this chapter, the latter consists of the foreign in-terest rate, iFOR, minus the expected appreciation (if any) in the value of the dollar.
For a graphical pre sen ta tion of this analytical discussion of supply, see Exhibit 8- 4. Study it carefully before moving on to the discussion of the demand for dollars.
Using the same logic and analytical framework we used for supply, we now ask what factors, in addition to the exchange rate, could cause foreigners to alter their demand for
8-3
The Market for Dollars
Supply of Dollars
100
A
Quantity of Dollars/Month Yen/Dollar
Demand for Dollars
U.S. goods, ser vices, and securities and thus their demand for dollars in the foreign ex-change market. Remember that ex-changes in the demand for dollars cause the demand curve for dollars to shift. We begin by identifying the major factors that can alter demand:
1. Changes in foreign real income. Ceteris paribus, changes in foreign real income and the demand for dollars are positively related. For example, if foreign real incomes rise, ceteris paribus, foreign fi rms and house holds will have more funds to spend and save.
Accordingly, they will demand more of their own goods, ser vices, and securities, as well as more imported goods, ser vices, and securities. Thus, as foreign real incomes grow, ceteris paribus, the demand for dollars, refl ecting the increased supply of yen to execute transactions, will grow. Following similar reasoning, if foreign incomes fall, the demand for dollars will also fall, ceteris paribus.
2. Changes in the foreign ( yen) price of foreign goods relative to the foreign price of U.S. goods.
Ceteris paribus, changes in, say, the yen price of Japa nese goods relative to the yen price of U.S. goods and the demand for dollars are positively related. To see why, as-sume infl ation accelerates in Japan, but there is no infl ation in the United States. The Japa nese infl ation will raise the yen price of Japa nese goods relative to the yen price of U.S. goods. As a result, foreigners will demand more U.S. goods and, thus, more dollars, ceteris paribus. If U.S. infl ation rises relative to infl ation in Japan, foreigners will demand fewer dollars, ceteris paribus.
3. Changes in U.S. interest rates relative to foreign interest rates. A positive relationship also exists between changes in U.S. interest rates relative to foreign rates and the demand for dollars. For example, suppose that, initially, the interest rate on both foreign This exhibit begins with an initial equilibrium exchange rate of 100 yen. Assume that the equilibrium is now disturbed by a change in one of the factors that affect the supply of dollars, say, a rise in U.S. in-come, which increases the supply of dollars, as shown by the rightward shift of the supply curve. The new equilibrium at point B results in a depreciation of the dollar as the equilibrium exchange rate falls from 100 yen to 50 yen. Note that a rise in the prices of U.S. goods relative to the dollar prices of foreign goods, or a rise in foreign interest rates relative to U.S. interest rates, would have produced a similar in-crease in supply and depreciation of the exchange rate.
8-4
Changes in the Exchange Rate: The Role of Changes in Supply
Quantity of Dollars/Month Yen/Dollar
Exchange Rate Supply of Dollars
Supply of Dollars after Rise in U.S. Income
Demand for Dollars A
B 100
50
government bonds and U.S. Trea sury bonds is 6 percent. Portfolio managers in Ja-pan, noticing the identical rates and recognizing the benefi ts of diversifi cation, hold some of both types of bonds in their portfolios. Now, interest rates in the United States rise. As a result, the demand for U.S. securities rises, as does the demand for dollars, ceteris paribus. Likewise, if interest rates in Japan fall, the demand for dollars rises, ceteris paribus.7 More on this later in the chapter.
These points are illustrated graphically in Exhibit 8- 5. Study this exhibit carefully before moving on. Make sure that you note the similarities between the factors that cause changes in the demand for dollars and the factors that cause changes in the supply of dollars.
Increases in U.S. real income, in U.S. prices relative to foreign prices, and in foreign interest rates relative to U.S. interest rates all increase the supply of dollars, and vice versa. In-creases in foreign real income, in foreign prices relative to U.S. prices, and in U.S. interest rates relative to foreign interest rates all increase the demand for dollars, and vice versa.