Reflective Exercise: Exchange rates – a question of demand and supply
1
Scenario
This exercise examines the foreign exchange markets and considers if they can be
analysed in the same way as the markets for ordinary physical commodities such as
cars. Does demand slope downward and supply slope upward for currencies?
Section 1: Setting the framework for investigating this question
A
Tick however many of the following you think appropriate
We will start from considering demand, supply and equilibrium as
these are important in any market.
Although there are many exchange rates we will concentrate on
one for simplicity.
Since governments intervene with the exchange rate this means
we cannot use demand and supply analysis.
£s (or €s or $s or other currencies) do not have a price; they are
simply the means of buying goods.
The price of pounds sterling can be expressed as how much of
another currency we will get in exchange for £1.
feedback page 4
B
Tick however many of the following you think appropriate
An appreciation of the pound is when the £:€ exchange rate rises.
An appreciation of the euro is when the €:£ exchange rate rises.
In examining the foreign exchange market we draw the demand
and supply diagram from one currency’s point of view
Since foreign currencies must be seen in relation to each other we
have to focus on both currencies simultaneously.
feedback page 4
C
Tick however many of the following you think appropriate
Imports affect the demand of pounds.
Imports affect the supply of pounds.
If UK residents are buying goods or assets from Germany this gives
rise to a demand for euros.
If UK residents are buying goods and assets from Germany this
gives rise to a supply of euros.
If UK residents are buying goods and assets from Germany this
gives rise to a supply of pounds.
feedback page 4
a
b
c
d
e
a
b
c
d
a
b
c
d
e
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Exchange rates – a question of demand and supply
2
Section 1: Setting the framework (cont)
We will assume in our example that the exporting or importing company keeps the
price the same in its home currency. (You may want to consider what happens if we
relax this assumption.)
D
a
b
c
d
Tick however many of the following you think appropriate
A company in Germany charges €10 for its good. If the
exchange rate falls from £1:€1.5 to £1:€1.3 this will make this good
more expensive in England and reduce demand for the good.
A company in Germany charges €10 for its good. If the
exchange rate falls from £1:€1.5 to £1:€1.3 this will make this good
less expensive in England and increase demand for the good.
A company in the UK charges £10 for its good. If the exchange
rate falls from £1:€1.5 to £1:€1.3 this will make this good less
expensive in Europe and increase demand for the good.
A company in the UK charges £10 for its good. If the exchange
rate falls from £1:€1.5 to £1:€1.3 this will make this good more
expensive in Europe and reduce demand for the good.
feedback page 5
Now, given the answers to D, we need to consider the demand and supply curves of
£s with a depreciation of the currency. We are concerned here with movements
along the demand or supply curves caused by changes in the exchange rate (that is
a ‘price’ change, not a shift of the curves).
E
a
b
c
d
e
f
Tick however many of the following you think appropriate
The depreciation reduces the demand for imports and the supply
of £s is reduced.
The depreciation reduces the demand for imports and the supply
of £s is increased.
The depreciation reduces the demand for imports but this can
increase or decrease the supply of £s.
The depreciation increases the demand for exports and the
demand for £s is increased.
The depreciation increases the demand for exports and the
demand for £s is reduced.
The depreciation reduces the demand for imports but this can
increase or decrease the demand for £s.
feedback page 5
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Exchange rates – a question of demand and supply
3
Section 2
(a) Can foreign exchange markets be analysed in the same way as the markets
for ordinary physical commodities? What are the similarities and differences?
Yes
No
Partly
(b) Does demand slope downward and supply slope upward for currencies and
why?
Yes
No
Sometimes
Explain your answers below. Remember to use what we have covered in section 1
in answer this question. Try to use the two diagrams in your explanation.
------------------------------------------------------------------------------------------------Your answer…
The foreign exchange market
Exchange Rate
(i)
(ii)
Exchange Rate
↑
Appreciation
↑
Appreciation
S1
£1:$1.5
£1:$1.5
D2
D1
S2
N1
Numbers of pounds (£s)
N1
Numbers of pounds (£s)
You can continue your answer on another sheet if needed…
feedback page 6
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Exchange rates – a question of demand and supply
4
Feedback Section 1: Setting the framework
A
People and firms want to obtain foreign exchange for various purposes and this
gives rise to a demand for (and supply of) currencies, in much the manner of other
goods and services. Although governments can affect the functioning of markets,
this does not stop market forces from being important, thus (a) is correct not (c).
We always like to simplify where possible and if we can understand the principles
against one other currency, we can then generalise to others: thus (b) is also
correct. In this example we will consider the £:€ rate.
On the foreign exchange market we are buying and selling £s for foreign currency.
If someone wants to buy £1 how much will it cost? That is how much foreign
currency has to be paid? This is the price of £s and is given by the exchange rate:
thus (e) is correct, not (d).
B
Since buying pounds is equivalent to selling €s (and vice versa) it is very important
when examining the foreign exchange (or FOREX) market always to be clear from
which currency’s point of view we are examining the situation (thus (c) is correct).
When we write currencies £:€, we mean how much of 1 unit of the first is worth in
terms of the second. If, for instance, the exchange rate rises from £1: €1.5 to £1:
€1.6 the £ is worth more euros and this is an appreciation of the currency. Given
this, both (a) and (b) are correct, as (a) is from the point of view of £s and (b) the
point of view of euros. We can also express exchange rates as €/£ (euros per £). In
this case we would just write the second figure: a movement from 1.5 to 1.6 is an
appreciation of the £.
C
The demand and supply of foreign currency is a derived demand from people and
organisations buying and selling goods, services and assets from and to abroad. If
we are buying from abroad, that is importing, the person who is selling to us needs to
be paid in euros, not pounds. There is a need to change our £s into €s, giving rise to
a supply of £s and a demand for €s: thus (b), (c) and (e) are correct.
As we have seen both in this section and in section B, what is demand in one
currency is supply of the other and the ‘price’ can be expressed in two ways (£:€ or
€:£). When drawing a diagram of the foreign exchange market this means we have
to be careful to express everything from one currency’s point of view and be
consistent, or we shall muddle demand and supply.
From what we have covered so far, it may seem that we can consider the foreign
exchange market in terms of a standard demand and supply diagram. But
consider D and E…
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Exchange rates – a question of demand and supply
5
Feedback Section 1: Setting the framework (cont)
D
This section explores the effects on imports and exports of a depreciation of the £. It
is often useful to explore this kind of question with a numerical example that uses
simple figures, as we do here. For imports,
* if the price is 10€, then at £1: €1.5 the price in £s is £6.66.
* if the exchange rate is £1: €1.3 then the price is £7.69, i.e. this will make this good
more expensive in England and reduce demand for the good. (a) is correct.
For exports,
* if the price is £10, then at £1: €1.5 the price in €s is €15.00.
* if the exchange rate is £1: €1.3 then the price is £13.00, i.e. this will make this good
cheaper abroad and increase the demand for the good. (c) is correct.
Effect of depreciation on quantity of goods sold
A
Imports
B
Exports
ER
Price €s
Price £s
Price £s
Price €s
£1:1.5€
10€
£6.66
£10
15€
£1:1.3€
10€
£7.69
£10
13€
Higher price in £s
Lower price in €s
Lower demand
Higher demand
E
In answering this question we must make sure all the time that we are answering in
terms of £s. We also have to be clear that what happens to the demand and
supply of currencies depends on the expenditure, that is price x quantity. The table
below considers the price, quantity and expenditures.
For exports the answer is relatively straightforward. The demand for £s is increased as
the price in £s is the same and the quantity demanded has increased. Total
revenue, that is price x quantity (in £s) has increased. The demand of £s is increased
so the demand curve slopes downward.
For imports the price in £s has gone up, but the quantity sold has decreased. This
implies that revenue, the amount of £s supplied, can go up or down, depending on
the strength of the two effects and this will be determined by the elasticity of
demand for imports. The supply curve may be upward sloping if demand for
exports is elastic and downward sloping if it is inelastic. (c), (d) and (f) are correct.
Effect of depreciation on quantity of £s
Imports
Same
Higher
Lower
Exports
Lower
Same
Higher
Price in €s
Price in £s
Quantity of goods
sold
Revenue
? may increase or decrease
Increases
(If the exporter did not keep the price the same in £s, but took the opportunity to
increase it, this still must increase revenue as long this did not lead to an actual
increase in the € price.)
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Exchange rates – a question of demand and supply
6
Feedback Section 2: The approach of economics
(a)
What are the similarities to ordinary physical goods?
To a large extent the foreign exchange markets can be analysed in the same way
as other markets. We are concerned with demand, supply and equilibrium – the
same as in all other markets, as we saw in section 1A and B.
* The price of the currency is measured in terms of another currency, for instance,
how much a £ is worth in term of €s.
* Equilibrium is where demand equals supply.
But are there any differences?
The demand and supply of £s is a derived demand, depending on the purchases
and sales of goods, services and assets to and from abroad as we saw in section 1C
and1D. The horizontal axis is the total value of the currency bought and sold, £s in
our case, at each exchange rate. This, however, is not the same as with goods such
as cars or beef, where the horizontal axis is the physical quantity, not the total value
of what sales are worth, i.e. revenue.
(b)
This difference leads to a complication in regard to the slopes of demand and
supply that relates to our discussion in section 1E. We will consider each in turn.
* For exports the price (in £s) will either stay constant or may increase a little (if
exporters increase profit margins) if the exchange rate falls and the quantity sold
increases. This gives rise to a demand for currency which will slope downward
(shown as D1 in diagram (i) and D2 in diagram (ii)), as a decrease in the exchange
rate decreases the price in foreign currency and will increase the exports sold.
* With imports a decrease in the exchange rate may increase or decrease the
import expenditure as the price in £s goes up while the quantity of imports
purchased falls. If the demand for imports is elastic, the percentage decrease in
the price will be lower than the percentage increase in the quantity of imports and
the import expenditure will rise. This gives a supply of currency that increases if the
exchange rate falls and the supply curve will slope upwards as in diagram (i). The
reverse is true if the demand for imports is inelastic, as in diagram (ii).
Reflection
1.
2.
Yes
Partly
No
Do you understand how the graphs related to the
explanation? Can you work out what happens to the
supply currency in both diagrams if the exchange rate falls
from £1:€1.5 to £1:€1.4?
Do you understand why the feedback only discusses the
slopes of the demand and supply curves and not shifts in
them?
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Exchange rates – a question of demand and supply
7
Notes for lecturers
Objectives of the exercise and prerequisites
Learning Focus: Developing an understanding of the foreign exchange markets by
considering the application of demand and supply analysis and the complications
with this.
Threshold Concepts that are important in this learning are economic modelling,
particularly the role of simplifying assumptions, elasticity, and incentives.
Prior Knowledge Required
Students need to be familiar with demand, supply and elasticity. The exercise
can be used to introduce exchange rates or to reinforce aspects covered in
lectures.
Sequencing and timing
1. With this exercise, the feedback to section 1 parts A, B and C is better
given to students before they attempt section 1 parts D and E (these sets
of answers are provided on separate pages so that this can be done with
ease).
2. The exercise will take around 30-40 minutes to complete.
3. The exercise ends with a series of questions reflecting on the diagrams.
Since students are often confused by diagrams we would recommend not
skipping this final section.
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.