MEASURING EXCHANGE RATE MOVEMENTS

When a foreign currency’s spot rate at two different times are compared, the
spot rate at the more recent date is denoted S and the spot rate at the earlier
date is denoted as St−l. The percentage change in the value of the foreign
currency is then computed as follows:

A positive percentage change indicates that the foreign currency has

appreciated, and a negative percentage change indicates that it has
depreciated.
 EXCHANGE RATE EQUILIBRIUM
The price of a currency is determined by the
demand for that currency relative to its supply.
Thus, for each possible price of a British pound,
there is a corresponding demand for pounds
and a corresponding supply of pounds for sale
(to be exchanged for dollars). At any given
moment, a currency should exhibit the price at
which the demand for that currency is equal to
supply; this is the equilibrium exchange rate.
 Demand for a Currency

The British pound is used here to explain exchange rate equilibrium. The United
Kingdom has not adopted the euro as its currency and continues to use the pound. The
U.S. demand for British pounds results partly from international trade, as U.S. firms
obtain British pounds to purchase British products. In addition, there is U.S. demand
for pounds due to international capital flows, as U.S. firms and investors obtain pounds
to invest in British securities.
A hypothetical number of pounds that would be demanded under several different values of
the exchange rate. At any point in time, there is only one exchange rate; this shows how many
pounds would be demanded at various exchange rates for a given time. This demand
schedule is downward sloping because corporations and individuals in the United States
would purchase more British goods when the pound is worth less. Conversely, if the pound’s
exchange rate is high then corporations and individuals in the United States are less willing to
purchase British goods (since the products or securities could be acquired at a lower price in
the United States or other countries).
 Supply of a Currency for Sale

A supply schedule of pounds for sale in the foreign exchange

market can be developed in a manner similar to the demand
schedule for pounds. Above diagram shows the quantity of pounds
for sale (supplied to the foreign exchange market in exchange for
dollars) corresponding to each possible exchange rate at a given
time. One can clearly see a positive relationship between the value
of the British pound and the quantity of British pounds for sale
(supplied),
 Equilibrium

The demand and supply schedules for British pounds are combined in diagram for a
given moment in time. At an exchange rate of $1.50, the quantity of pounds demanded
would exceed the supply of pounds for sale. Consequently, the banks that provide
foreign exchange services would experience a shortage of pounds at that exchange rate.
At an exchange rate of $1.60, the quantity of pounds demanded would be less than the
supply of pounds for sale; in this case, banks providing foreign exchange services would
experience a surplus of pounds at that exchange rate. According to diagram , the
equilibrium exchange rate is $1.55 because this rate equates the quantity of pounds
demanded with the supply of pounds for sale.
 Change in the Equilibrium Exchange Rate
Changes in the demand and supply schedules of a currency
force a change in the equilibrium exchange rate in the foreign
exchange market. Before considering the factors that could cause
changes in the demand and supply schedules of a currency, it is
important to understand the logic of how such changes affect the
equilibrium exchange rate. There are four possible changes in
market conditions that can affect this rate, and each condition is
explained with an application to the British pound.

1. Increase in Demand Schedule

2. Decrease in Demand Schedule
3. Increase in Supply Schedule
4. Decrease in Supply Schedule
 Increase in Demand Schedule
The U.S. demand for British pounds can change at
any time. Assume that the demand for British
pounds in the foreign exchange market increases
but that the supply schedule of British pounds for
sale has not changed. Then the amount of pounds
demanded in the foreign exchange market will be
more than the amount for sale in the foreign
exchange market at the prevailing price (exchange
rate), resulting in a shortage of British pounds.
 Decrease in Demand Schedule
Suppose that conditions cause the demand for
British pounds to decrease but that the supply
schedule of British pounds for sale has not
changed. Under these conditions, the amount
of pounds demanded in the foreign exchange
market will be less than the amount for sale in
the foreign exchange market at the prevailing
price
 Increase in Supply Schedule
Assume that conditions cause that British demand for
U.S. dollars to increase. Then there is an increase in
the amount of British pounds to be supplied in the
foreign exchange market even though the demand
schedule for British pounds has not changed. In this
case, the amount of the currency supplied in the
foreign exchange market will exceed the amount of
British pounds demanded in that market at the
prevailing price, resulting in a surplus of British
pounds
 Decrease in Supply Schedule
There is a decrease in the supply of British
pounds to be exchanged for dollars in the
foreign exchange market, although the
demand schedule for British pounds has not
changed. In this case, the amount of pounds
supplied will be less than the amount
demanded in the foreign exchange market at
the prevailing price, resulting in a shortage of
British pounds.