Feb 22 2010

## Another question from the Help Desk: Relative price levels as a determinant of exchange rates

One feature of Economics in Plain English several students and teachers have found helpful over the years is the Econ Help Desk, where readers can get questions about basic economic concepts answered personally by me.

Recently I received the following email from an AP Macroeconomics teacher in the United States:

I have a question about graphs that illustrate how trade preferences (specifically Supply and Demand shifts), affect P, Q and Pe on Supply-Demand GRAPHS of Currency Exchange.

In teaching my AP Macro students about this concept, I have reached a gap in our full understanding how to graph the Supply and Demand of Yen, or Euro (Price in USD).

For example, if the Price levels rise in the U.S., relative to Japan’s, and consequently, the U.S. demands more Japanese cars and stereos, the only label that we ever see for the x-axis is “Q” or Quantity, or Qe, a vertical line that represents the starting “market clearing price”, of .01USD=1Y. When DEMAND or SUPPLY shifts, the only change that I ever see labeled on the graphs is the Y-Price in USD of Yen, but descriptions simply talk about the Y=1.

When Demand or Supply shifts (in response to increased demand for Yen), and there is a new higher or lower USD Price for Yen, respectively, does the vertical line for Q simply shift outward (continuing to represent Y=1) at whatever the new Price Equilibrium becomes (simply meaning just more “1s” of them in circulation (at each new Pe market-clearing point)?

Thanks

Here is my response:

Exchange rates can be determined by several factors, including relative price levels, relative interest rates, tastes and preferences of domestic and international consumers, relative income levels at home and abroad and speculation by currency traders. As you say, an increase in the price level of goods produced in United States (say, Fords), ceteris paribus, should lead to an increase in demand among American consumers for goods produced in Japan (say, Hondas), which now appear relatively cheaper. Demand for Yen increases among American households who wish to buy Japanese goods. The USD price of Yen then rises in the Yen market. Since Japanese holders of Yen now receive more USD for each Yen, they will provide more Yen (this is another way of saying with an increase in demand for Yen, the quantity supplied of Yen increases).

Theory would say that there is no increase in the supply of Yen following an increase in Demand by American consumers, only an increase in quantity supplied. The Yen clearly appreciates, as the USD/Yen exchange rate rises. Now, there is another side to this story. The Yen market refers to the market for Yen in the United States. Yen will appreciate in the United States. Simultaneously, USD will depreciate in Japan, as Americans buy more Japanese goods, they are supplying more USD in the USD market in Japan. Here the “price” or the exchange rate is Yen/USD. The Yen price of a USD will fall as the supply of USD increase as Americans exchange their dollars for Yen to buy the relatively cheap Japanese goods.

The “market-clearing price” in forex markets is the exchange rate that prevails in a floating exchanged rate system where exchange rates are determined solely by supply and demand by international consumers, investors, government, banks, and firms. Assume the Yen is trading for \$0.01. If , following inflation in the United States and the corresponding increase in demand for Yen, the value of the Yen remained at \$0.01, then the quantity demanded for Yen would exceed the quantity supplied. There would be shortages of Japanese goods in the United States, as Japanese goods are in greater demand yet their prices have not risen. In order to “clear the market” so to speak, the exchange rate must rise, to say \$0.012. Now, a Yen’s worth of goods “costs” Americans 20% more than previous, making them less attractive over time. Likewise, a dollar’s worth of goods “costs” Japanese consumers 20% less, since the dollar is weaker in Japan.

As you can foresee, the floating value of the Yen should lead to relatively balanced trade between Japan and the US. The US current account will initially move towards deficit as inflation makes American goods more expensive, however, as demand for Japanese goods increases, the value of the Yen rises making Japanese goods more expensive, which will eventually reduce their appeal to American consumers who will once again begin consuming more American goods and importing less. Japanese will notice the weaker dollar makes US imports cheaper and begin importing more American products. The US current account should remain  balanced in the long-run in a floating exchange rate system.

I don’t know if you’ve had a look at my study guides on exchange rates and balance of payments, but those may help clarify graphically what I describe above:

I hope this clarifies your understanding of how relative price levels help determine exchange rates!

Best,
Jason

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

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