Chapter 6
Supply-and-Demand View of Exchange Rates
Imports, Exports, and Exchange Rates
Deriving a Currency’s Supply Curve
Deriving a Currency’s Demand Curve
The Factors Affecting Exchange Rates
Terms of Trade and the Amount of Trade
Inflation
Service Trade, Income Flows, and Transfers
Foreign Investment
The Stability of Exchange Rates
TM6-1
The Conditions Required for Instability
Unstable Exchange Rates and the Balance of Trade
Short-Run versus Long-Run Trade Elasticities and the J Curve
TM6-2
Imports, Exports, and Exchange Rates – Deriving a Currency’s Supply Curve
1. Two Axes of the Supply Curve of a Currency
(1) The horizontal axis: the amount of the currency supplied
Values involve the multiplication of prices and quantities, and they respond
differently than do quantities.
(2) The vertical axis: the price of the currency (the exchange rate)
2. The supply curve of a currency derives, at least in part, from a country’s demand for
imports.
The amount of the currency supplied is equal to the value of imports.
3. An Example: British Imports of Wheat
(1) Three assumptions:
◎ the world price of wheat is $3 per bushel
◎ wheat is traded without tariffs and other restrictions
◎ the world price of wheat is not influenced by Britain’s imports
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(2) Figure 6.1. Deriving the Supply of Pounds
Points
(a), (b)
A, A’
B, B’
C, C’
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(1)
(2)
Exchange rates The Pound price
of wheat
($/￡)
(￡)
= $3 ÷ (1)
1.5
2.0
1.7
1.76
2.0
1.5
(3)
(4)
The quantity of The number of
wheat imports pounds supplied
(￡)
= (2) × (3)
0
0
0.75
1.32
1.5
2.25
Deriving a Currency’s Demand Curve
1. The currency’s demand curve is derived from the country’s export supply curve.
2. An Example: British’s Exports of Oil
(1) The demand for pounds to pay for Britain’s oil exports is equal to the value
of these exports.
(2) Three assumptions:
◎ the world price of oil is $25 per barrel
◎ oil is traded without tariffs and other restrictions
◎ the world price of oil is not influenced by Britain’s exports
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(3) Figure 6.2. Deriving the Demand for Pounds
Points
(a), (b)
D, D’
E, E’
F, F’
TM6-6
(1)
(2)
Exchange rates The Pound price
of oil
($/￡)
(￡)
= $3 ÷ (1)
2.0
12.5
1.8
13.89
1.5
16.67
(3)
(4)
The quantity of The number of
oil exports
pounds
demanded (￡)
= (2) × (3)
0
0
0.1
1.389
0.2
3.33
The Factors Affecting Exchange Rates – Terms of Trade and the Amount of
Trade
1. Figure 6.3. The Exchange Rate from Imports and Exports
We see that equality of supply and demand occurs at an exchange rate of
approximately $1.75/￡.
2. The Shifts of the Demand Curve for Pounds
a higher world price of oil (exports)
or
an increase in the quantity of oil exported at each price
↓
an increase in the value of exports at each exchange rate
↓
shifts the demand curve for pounds to the right
↓
pounds appreciate
TM6-7
3. The Shifts of the Supply Curve of Pounds
a higher world price of wheat (imports)
or
an increase in the quantity of wheat imported at each price
↓
an increase in the value of imports at each exchange rate
↓
shifts the supply curve of pounds to the right
↓
pounds depreciate
4. Terms of Trade
(1) The price of a country’s exports relative to the price of its imports is called
the country’s terms of trade.
(2) A country’s terms of trade are said to improve when the price of its exports
increases relative to the price of its imports. The pounds will appreciate in
TM6-8
value as a result of an improvement of Britain’s terms of trade.
(3) The pound will also appreciate if the quantity of exports increases relative to
the quantity of imports.
TM6-9
Inflation
1. Inflation affects the competitiveness of one country’s products versus the same or
similar products from another country. (Terms-of-trade effects concern export
versus import prices, where the exports and imports are different products.)
2. Deriving the Import Demand Curve
(1) Figure 6.4. Deriving the Demand for Imports
◎ Wheat market in Britain: the demand and supply schedule
◎ Excess demand: Britain becomes an importer of wheat
the quantity demanded is measured by the distance between DWUK and
SWUK at each price
(2) The British import demand curve DMUK
the quantities of wheat imported at each price against the pound prices of
wheat
TM6-10
3. Deriving the Export Supply Curve
(1) Figure 6.5. Deriving the Export Supply Curve
◎ Oil market in Britain: the demand and supply schedule
◎ Excess supply: Britain becomes an exporter of oil
the quantity supplied is measured by the distance between SOUK and DOUK
at each price
(2) The British export supply curve SEUK
the quantities of oil exported at each price against the pound prices of oil
4. Inflation, Import Demand, and Export Supply
(1) Let us assume that Britain experiences a 25 percent inflation.
◎ The British demand curves for wheat and oil at the end of the year will
be 25 percent higher than at the beginning of the year. That is, they are
shifted vertically upward by 25 percent.
TM6-11
◎ The British supply curves for wheat and oil are shifted vertically
upward by 25 percent. The supply curves for competitive firms are their
marginal cost curves.
(2) The left-hand diagrams in Figure 6.6.: the demand and supply curves for
wheat and oil before and after 25 percent inflation
(3) The right-hand diagrams in Figure 6.6.: the demand for imports and supply
of exports before and after 25 percent inflation
◎ Since the slopes of the supply and demand curves for wheat are the
same before and after inflation, the slope of the demand curve for wheat
imports is the same before and after inflation.
◎ DMUK(P1) is above DMUK(P0) by 25 percent, not only at the intercept
with the price axis but at every other quantity of imports.
TM6-12
5. Inflation in Only One Country
(1) Figure 6.7.(a): The supply and demand curves for pounds that are implied by
the demand curve for imports and supply curve of exports when inflation of 25
percent occurs in Britain but not in the United States.
◎ the supply of pounds
the supply of pounds = the pound price of imports × the quantity of imports
25% higher
25% higher
unchanged
◎ the change in exchange rate
The dollar price of
The pound price of
wheat
wheat
Before inflation
$4
￡2
$2/￡
After inflation
$4
￡2.5
$1.6/￡
TM6-13
The exchange rate
25% higher
20% lower
At an exchange rate that is 20 percent lower there is a 25 percent higher supply of
pounds.
◎ Inflation of 25 percent shifts the supply curve for pounds downward by
20 percent and to the right by 25 percent.
(2) The effect of inflation on the demand for pounds
(3) Compare the equilibrium where S￡(P1) intersects D￡(P1) with the equilibrium
where S￡(P0) intersects D￡(P0)
◎ the pound depreciates by 20 percent
◎ the quantity of pounds traded increases by 25 percent
6. Inflation also in other Countries
(1) We allow for increases in the dollar prices of the imported and exported
TM6-14
products. Let us assume U.S. inflation is also 25 percent.
(2) Figure 6.7.(b): the supply curve of pounds
◎ the supply of pounds
the supply of pounds = the pound price of imports × the quantity of imports
25% higher
25% higher
unchanged
◎ the change in exchange rate
The dollar price of
The pound price of
The exchange rate
wheat
wheat
Before inflation
$3
￡2
$1.5/￡
After inflation
$3.75
￡2.5
$1.5/￡
25% higher
25% higher
unchanged
◎ Inflation of 25 percent in both the Britain and the United States shifts
TM6-15
the supply curve for pounds to the right by 25 percent at each exchange
rate.
(3) The effect of inflation on the demand for pounds
(4) Compare the equilibrium where S￡(P1) intersects D￡(P1) with the equilibrium
where S￡(P0) intersects D￡(P0)
◎ the exchange rate is unchanged
◎ the quantity of pounds traded increases by 25 percent
7. More generally, the analysis above can be extended to show that a country’s
exchange rate depreciates by approximately the extent that the country’s inflation
exceeds that of other countries.
TM6-16
Service Trade, Income Flows, and Transfers
1. Service Trade
(1) Imports and exports of services respond to exchange rates in the same way as
do imports and exports of merchandise. This has the effect of shifting both S￡
and D￡ to the right.
(2) If exports of services exceed imports of services, then the currency demand
curve is shifted to the right more than the currency supply curve. The exchange
rate is higher than before.
2. Income Inflows
(1) The supply and demand for a currency from payments and receipts of interest,
dividends, rents, and profits do not respond to exchange rates in the same
manner as the currency supply and demand from imports and exports of
merchandise or services.
TM6-17
(2) We can add the value of income exports to the currency demand curve, and
the value of income imports to the currency supply curve.
(3) The higher income exports are relative to income imports, the higher is the
exchange rate.
3. Transfer
(1) We add the amount of transfer received from abroad to a currency’s demand
curve and the amount sent abroad to the supply curve.
(2) Net inflows of transfers tend to increase the value of a currency and net
outflows of transfers tend to reduce it.
TM6-18
Foreign Investment
Increases in interest rates or expected returns
↓
an increase in demand for this country’s currency from increased foreign investment
(shifts the demand curve to the right)
and
a decrease in supply of this country’s currency from a decrease in residents’
investment abroad
(shifts the supply curve to the left)
↓
net flows of investment to this country
↓
increase the foreign exchange rate of this country’s currency
(the currency appreciates)
TM6-19
The Stability of Exchange Rates – The Conditions Required for Instability
1. The supply curve for pounds, S￡, is derived from the British demand for imports.
(1) ηm stands for import price elasticity
◎ηm > 1 means elastic, that is, when the price of imports falls, the
quantity of imports increases by a greater percentage than the price declines
◎ηm < 1 means inelastic, that is, when the price of imports falls, the
quantity of imports increases by a smaller percentage than the price
declines
2. Figure 6.8. Currency Supply and Import Elasticity
DmUK is an import demand curve.
(1) DmUK(ηm > 1) is an elastic import demand curve.
◎ S￡(ηm > 1) is the currency supply curve derived from DmUK(ηm > 1).
TM6-20
◎ It is seen to slope upward.
(2) DmUK(ηm < 1) is an inelastic import demand curve.
◎ S￡(ηm < 1) is the currency supply curve derived from DmUK(ηm < 1).
◎ It is seen to slope downward.
Points
(a), (b)
A, A’
B, B’
C, C’
(1)
(2)
Exchange rates The Pound price
of wheat
($/￡)
(￡)
= $3 ÷ (1)
1.5
2.0
1.7
1.76
2.0
1.5
(3)
(4)
The quantity of The number of
wheat imports pounds supplied
(￡)
= (2) × (3)
1.5
3
1.6
2.82
1.7
2.55
When the demand for imports is inelastic, the supply curve of the country’s
currency slopes downward.
TM6-21
3. Figure 6.9. Stability of Foreign Exchange Markets
shows two situations in which the currency supply curve slopes downward.
(1) Figure 6.9.(a): the demand curve for pounds is steeper than the supply curve
a small decline in the exchange rate below equilibrium
↓
causes an excess supply of pounds
↓
pushes the value of pound even lower
◎ the equilibrium exchange rate in this figure is unstable
(2) Figure 6.9.(b): the demand curve for pounds is flatter than the supply curve
a small decline in the exchange rate below equilibrium
↓
causes an excess demand for pounds
↓
pushes up the value of pound
TM6-22
◎ the equilibrium exchange rate in this figure is stable
(3) A sufficient condition for instability is that the supply curve slopes
downward and the demand curve is steeper at equilibrium than the supply curve.
TM6-23
Unstable Exchange Rates and the Balance of Trade
1. The balance of trade is the value of exports minus the value of imports.
2. Effects of a depreciation in domestic currency on
(1) the value of imports
a depreciation
↓
increases the price of imports in terms of domestic currency
↓
reduces the quantity of imports
↓
the value of imports is high if import demand is inelastic
↓
the balance of trade tends to be worsen
TM6-24
◎ An example: domestic currency is NT$
Exchange rate The price of The price of The quantity
(NT$/$)
imports ($) imports in
of imports
terms of NT$
30
5
150
1,000
Before
depreciation
After
40
depreciation
5
200
800
33.33%
20% lower
higher
inelastic
(2) the value of exports
a depreciation
↓
reduces the price of exports in terms of foreign currency
↓
increases the quantity of exports
TM6-25
The value of
imports
(NT$)
150,000
160,000
↓
the value of exports is increases
↓
the balance of trade tends to be improved
◎ An example: domestic currency is NT$
Exchange rate The price of The price of The quantity
(NT$/$)
exports (NT$) exports in
of imports
terms of $
30
1,200
40
1,000
Before
depreciation
After
40
depreciation
1,200
30
1,200
The value of
imports
(NT$)
1,200,000
1,440,000
(3) Even if depreciation increases the value of imports, the balance of trade is
worsened only if the value of exports increases less than the value of imports.
TM6-26
Short-Run versus Long-Run Trade Elasticities and the J Curve
1. If import demand and export supply are more inelastic in the short run than the long
run, we may find that a depreciation worsens the balance of trade in the short run
but subsequently improves it.
(1) After a depreciation and consequent increase in import prices, a country’s
residents might continue to buy imports both because they have not adjusted
their preferences toward domestically produced substitutes (an inelastic demand
curve) and because the domestic substitutes have not yet been produced (an
inelastic supply curve).
(2) Only after producers begin to supply what was previously imported and after
consumers decide to buy import substitutes can import demand fully decline
after a depreciation.
(3) Exports expand from a depreciation only after suppliers are able to produce
TM6-27
more to export and after foreign consumers switch to these products.
2. The J-curve effect is the phenomenon of a worsening and subsequent improvement
of the trade balance after a depreciation.
TM6-28