Exchange rates are prices (Exchange Rates), set by supply and demand like any market price. The question is who supplies and who demands a currency.
Key idea
In the market for dollars, demand comes from foreigners who need dollars to buy U.S. goods, services and assets. Supply comes from Americans who sell dollars to buy foreign goods, services and assets. Every trade has a mirror: demand for dollars by Europeans is a supply of euros, and supply of dollars by Americans is a demand for euros.
Why it works
A European tourist in New York must pay in dollars, so she trades euros for dollars: she demands dollars and supplies euros in the same trade. An American buying a French watch trades dollars for euros: he supplies dollars and demands euros. The price on the vertical axis of the dollar market is euros per dollar; in the euro market it is dollars per euro, the reciprocal. Whatever happens in one market shows up, mirrored, in the other.
| Transaction | Market for dollars | Market for euros |
|---|---|---|
| Europeans buy U.S. goods or assets | demand for dollars | supply of euros |
| Americans buy European goods or assets | supply of dollars | demand for euros |
Worked examples
Worked example: Who demands dollars?
(a) A Japanese company buys U.S. Treasury bonds. (b) An American family vacations in Mexico.
- (a) It needs dollars to buy the bonds: demand for dollars.
- (b) The family sells dollars for pesos: supply of dollars (and demand for pesos).
Answer: (a) demand for dollars; (b) supply of dollars
Worked example: Equilibrium
Demand for dollars: $Q_D = 220 - 200e$; supply: $Q_S = -140 + 200e$, with $e$ in euros per dollar and $Q$ in billions of dollars a day.
- $220 - 200e = -140 + 200e$, so $360 = 400e$ and $e = 0.90$.
- $Q = 220 - 200(0.90) = 40$ billion dollars a day.
Answer: 0.90 euros per dollar
Common mistake
Forgetting the mirror market: when Europeans demand more dollars, they also supply more euros. Check: in every currency trade, one currency is bought and the other is sold.