The Equilibrium Exchange Rate

Meaning of Equilibrium Exchange Rate

In order to really understand the meaning of an Equilibrium Exchange Rate, we must first understand what determines the demand and the supply of a currency. In this case, let's discuss what might impact the supply and demand for USD and JPY.

In this two-country world, you can only buy USD by selling JPY, and you can only buy JPY by selling USD. Stated another way, since you can only buy and sell a currency by exchanging it for another currency, when you buy JPY, you can only do so by providing, or selling USD, and when you buy USD, you can only do so by providing, or selling JPY.

As a result, the demand for USD occurs when someone needs to acquire something in USD (in exchange for JPY), and the supply of USD occurs when someone needs to acquire something in JPY (in exchange for USD), and vice versa.

Now, how do economists talk about why or when people would need one currency in exchange for another?

They do so by categorizing the exchange of currencies in terms of the transactions between them. In our two-country example, we will define this as the flow of goods, services, and financial assets between the U.S. and Japan, and we will call it the Balance of Payments.

Determinants of Equilibrium Exchange Rate

So what determines the demand for USD? Well, at the risk of stating the obvious, demand for USD occurs when people want to buy U.S. goods, services, and financial assets. In other words, since all U.S. goods, services, and financial assets are sold in USD, you need USD to buy them.

Figure 1. Demand for USD, StudySmarter Originals

Conversely, what determines the supply of USD? Well, since we know that the only way to buy JPY, is by selling (or supplying USD), the supply of USD occurs when people want to buy Japanese goods, services, and Financial Assets.

As we can see in Figure 2, the supply of USD slopes upward and to then right in line with the reasoning we provided.

Figure 2. Supply for USD, StudySmarter Originals

Equilibrium Exchange Rate Example

Now that we understand the forces that generate the supply and demand for USD, all we need to do is bring them together to understand how we can achieve the equilibrium exchange rate.

Now instead of hamburgers, let's consider a more realistic example. We know that the exports and imports of a country's goods and services are one of the key determinants of the Balance of Payments between countries. We also know that the purchase of financial assets is another key component of the Balance of Payments between countries.

Therefore, let's consider the impact changes in exchange rates can have on exports, imports, and the purchase of financial assets. Let's stick with our two country example.

If the value of USD increases relative to the JPY, or appreciates, that means U.S. goods, services, and assets become more expensive to Japanese residents, thereby driving demand for those goods, services, and assets down.

At the same time, if the value of USD increases relative to the JPY, that means the value of JPY decreases relative to the USD, or depreciates, making Japanese goods, services, and assets cheaper to buy for U.S. residents, and drives demand for Japanese goods, services, and assets in the U.S. up.

Put another way, it's the exchange rate that ensures that the balance of payments between countries equals zero.

Equilibrium exchange rate graph

Let's analyze Figure 3 to better understand how and why equilibrium exchange rate occurs.

Let's assume that it's the first day of world trade, and neither the U.S., nor Japan have a solid understanding of how exchange rates work. In an effort to be able to sell goods, services, and assets to each other, they decide that a good starting exchange rate will be $1 USD to ¥200 JPY.

Let's also assume that hamburger trade is at the top of the import - export list because both countries make great hamburgers. Since we know that a hamburger in the U.S. costs $1 USD, and a hamburger in Japan costs ¥128 JPY, imports of Japanese hamburgers into the U.S. skyrocket because they're significantly cheaper than U.S. hamburgers. In other words, I can buy an imported Japanese hamburger for only $0.64USD since the cost of a Japanese Hamburger is only ¥128 JPY, and at the $1 USD to ¥200 JPY exchange rate, I only need $0.64 USD to get ¥128 JPY!

In order to import more Japanese hamburgers, U.S. residents need to acquire more Japanese Yen. This will increase the quantity demanded for JPY, and the only way to get JPY is by exchanging, or supplying USD. This can be seen as an upward movement along the Supply curve in Figure 3.

Similarly, since U.S. hamburgers are relatively expensive, Japanese resident stop buying them, thereby reducing the quantity demanded of USD. This is seen by the downward movement along the Demand curve.

When will the process of moving down the Demand curve and up the Supply curve stop? If you guessed "when the price of hamburgers are equal in both countries" then you guessed correctly!

Coincidentally, this is also the exchange rate required for the sum of the balance of payments between Japan and the U.S. to equal zero!

Figure 3. Equilibrium exchange rate through PPP, StudySmarter Originals

Shift in the demand curve for a currency

Now, what would happen if there was a shift in demand for USD?

Let's assume that the U.S. Government decided to increase interest rates. We know that one of the components of the demand for a currency includes that country's financial assets, and since a Government Bond is considered a financial asset whose return, or interest rate, has just increased, this would shift the demand for USD to the right as shown in Figure 4 below. In other words, demand for USD in the foreign exchange market increases as Japanese investors convert JPY into USD to buy more U.S. Bonds.

This is shown in Figure 4 by the shift of the demand curve from D₀ to D₁. At the current exchange rate of 1 USD for 128 JPY, there would be excess demand. The horizontal distance between points 1 and 2 shows excess demand. This excess demand would lead to the mechanism of bidding for USD at higher rates in order to acquire them, making the USD appreciate, ultimately establishing a new equilibrium point (Point 3) at an exchange rate of $1 USD to ¥150 JPY.

Figure 4. Demand shift for USD, StudySmarter Originals

Shift in the supply curve for a currency

Let's now consider a shift in supply for USD. What forces might shift the supply curve for a currency?

Let's assume the U.S. Government puts a quota on the import of Japanese hamburgers into the U.S. This has the effect of artificially limiting the quantity of Japanese hamburgers available for import into the U.S. Since there are less hamburgers available to import from Japan, less JPY are needed to buy the reduced quantity. Since less JPY are needed, less USD will need to be supplied at every exchange rate, and therefore supply of USD decreases.

This is shown in Figure 5 by the shift of the supply curve from S₀ to S₁. At the current exchange rate of 1 USD for 128 JPY, there would be a supply vacuum, or reduced supply. The horizontal distance between points 1 and 2 shows reduced supply. This reduced supply would lead to the mechanism of bidding for USD at higher rates in order to acquire them, making the USD appreciate, ultimately establishing a new equilibrium point (Point 3) at an exchange rate of $1 USD to ¥150 JPY.

Figure 5. Supply shift for USD, StudySmarter Originals

Government Policy Effects on Equilibrium Exchange Rates

Let's consider how government policies might impact the equilibrium exchange rate.

Government policies such as Fiscal Policy or Monetary Policy will definitely have an effect on equilibrium exchange rates but let's discuss why.

Assume the U.S. Central Bank decides to impose a Monetary Policy of increasing the interest rate. Since we know that demand for financial assets comprises one of the key flows between Japan and the U.S., and since U.S. Bonds are now more attractive because of the higher interest rate, or improved return, this will increase capital flows into the U.S., increasing the demand for USD. At the same time, USD capital flows out of the U.S. will decrease because U.S. bonds are more attractive to U.S. citizens as well, therefore reducing the supply of USD.

Since we know that these two effects will shift demand to the right, and shift supply to the left, other things being equal, an increase in a country’s interest rate will increase the value of its currency.

What if we consider a change in Fiscal Policy now?

Since the U.S. Government is also a consumer of goods and services, including imported goods and services, a change in Fiscal Policy can be as simple as Government buying fewer Japanese imports, thereby reducing the supply of USD. This will shift the USD supply curve to the left, and result in a higher USD equilibrium exchange rate.

Another way Governments can use fiscal policy to impact the equilibrium exchange rate is through taxation policy. Assume, for example, that the U.S. Government decides to decrease income taxes, such that all consumers now have more disposable income. With more disposable income come more purchases, including those of imported goods and services. As U.S. consumers purchase more Japanese goods and services, demand for the JPY will increase, thereby increasing the supply of USD, resulting in a rightward shift of the USD supply curve, and a lower USD equilibrium exchange rate.