Now shift the curves in the The Foreign Exchange Market. The usual shifters connect to ideas from earlier units: real interest rates and inflation.
Key idea
The main shifters of demand for and supply of a currency: tastes for a country's goods, relative incomes, relative price levels (inflation) and relative real interest rates, plus speculation and central bank purchases. For the dollar: higher U.S. real interest rates or higher foreign incomes raise demand for dollars (appreciation); higher U.S. incomes or higher U.S. inflation push the dollar down (depreciation).
Why it works
Ask who now wants more or fewer dollars. If U.S. real interest rates rise, foreign savers want U.S. bonds and must buy dollars: demand rises. If Europeans get richer, they buy more of everything, U.S. goods included: demand for dollars rises. If Americans get richer, they buy more imports and sell dollars to do it: supply rises. If U.S. prices rise faster than Europe's, U.S. goods look expensive: Europeans want fewer dollars and Americans supply more to buy cheaper European goods. Both push the dollar down.
| Event | Market for dollars | Dollar |
|---|---|---|
| U.S. real interest rates rise | demand ↑ | appreciates |
| Incomes in Europe rise | demand ↑ | appreciates |
| Incomes in the U.S. rise | supply ↑ | depreciates |
| U.S. inflation above Europe’s | demand ↓, supply ↑ | depreciates |
| Americans want more European goods | supply ↑ | depreciates |
Worked examples
Worked example: Higher U.S. inflation
Inflation in the United States runs well above Europe's. What happens to the dollar against the euro?
- U.S. goods get pricier compared with European goods.
- Europeans demand fewer dollars, and Americans supply more dollars to buy European goods.
- The dollar depreciates; the euro appreciates.
Answer: The dollar depreciates
Worked example: A demand shift with numbers
Demand for dollars is $Q_D = 150 - 100e$ and supply is $Q_S = -30 + 100e$, so $e = 0.90$. U.S. interest rates rise and demand grows by 20 at every rate. Find the new rate.
- New demand: $Q_D = 170 - 100e$.
- Set it equal to supply: $170 - 100e = -30 + 100e$, so $200 = 200e$.
- $e = 1.00$ euro per dollar: the dollar appreciated from 0.90.
Answer: 1.00 euro per dollar
Common mistake
Expecting higher U.S. inflation to strengthen the dollar. It makes U.S. goods dearer and tends to weaken the dollar. Check: would foreigners want more U.S. goods, or fewer, after U.S. prices jump?
See it with real data: the trade-weighted value of the U.S. dollar on the Economic Data page.