Exchange Rates and Macroeconomic Performance

People purchase a country’s currency for two quite different reasons: to purchase goods or services in that country, or to purchase the assets of that country – its money, its capital, its stocks, its bonds, or its real estate. Both of these motives must be considered to understand why demand and supply in the foreign exchange market may change.

One thing that can cause the price of the dollar to rise, for example, is a reduction in bond prices in American markets. Figure Shifts in Demand and Supply for Dollars on the Foreign Exchange Market illustrates the effect of this change.

Suppose the supply of bonds in the U.S. bond market increases from S ₁ to S ₂ in Panel (a). Bond prices will drop. Lower bond prices mean higher interest rates. Foreign financial investors, attracted by the opportunity to earn higher returns in the United States, will increase their demand for dollars on the foreign exchange market in order to purchase U.S. bonds. Panel (b) shows that the demand curve for dollars shifts from D ₁ to D ₂. Simultaneously, U.S. financial investors, attracted by the higher interest rates at home, become less likely to make financial investments abroad and thus supply fewer dollars to exchange markets. The fall in the price of U.S. bonds shifts the supply curve for dollars on the foreign exchange market from S ₁ to S ₂, and the exchange rate rises from E ₁ to E ₂.

Figure Shifts in Demand and Supply for Dollars on the Foreign Exchange Market

In Panel (a), an increase in the supply of bonds lowers bond prices to P ^b₂ (and thus raises interest rates). Higher interest rates boost the demand and reduce the supply for dollars, increasing the exchange rate in Panel (b) to E ₂. These developments in the bond and foreign exchange markets are likely to lead to a reduction in net exports and in investment, reducing aggregate demand from AD ₁ to AD ₂ in Panel (c). The price level in the economy falls to P ₂, and real GDP falls from Y ₁ to Y ₂.

The higher exchange rate makes U.S. goods and services more expensive to foreigners, so it reduces exports. It makes foreign goods cheaper for U.S. buyers, so it increases imports. Net exports thus fall, reducing aggregate demand. Panel (c) shows that output falls from Y ₁ to Y ₂; the price level falls from P ₁ to P ₂. This development in the foreign exchange market reinforces the impact of higher interest rates we observed in Figure Bond Prices and Macroeconomic Activity, Panels (c) and (d). They not only reduce investment—they reduce net exports as well.

Key concepts

· A bond represents a borrower’s debt; bond prices are determined by demand and supply.

· The interest rate on a bond is negatively related to the price of the bond. As the price of a bond increases, the interest rate falls.

· An increase in the interest rate tends to decrease the quantity of investment demanded and, hence, to decrease aggregate demand. A decrease in the interest rate increases the quantity of investment demanded and aggregate demand.

· The demand for dollars on foreign exchange markets represents foreign demand for U.S. goods, services, and assets. The supply of dollars on foreign exchange markets represents U.S. demand for foreign goods, services, and assets. The demand for and the supply of dollars determine the exchange rate.

· A rise in U.S. interest rates will increase the demand for dollars and decrease the supply of dollars on foreign exchange markets. As a result, the exchange rate will increase and aggregate demand will decrease. A fall in U.S. interest rates will have the opposite effect.

Unit 5.3 Demand, Supply, and Equilibrium in the Money Market

Learning objectives

Explain the motives for holding money and relate them to the interest rate that could be earned from holding alternative assets, such as bonds.