[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

curve for dollars represents the dollars demanded by the Japanese to purchase
American products and to make investments in the United States. At higher exchange
rates—when it takes more yen to buy one dollar—the Japanese demand lower quantities
of dollars, resulting in a demand curve that slopes downward to the right. The
equilibrium exchange rate, e e , lies at the intersection of the supply and demand
curves for dollars.
Now we can see how the exchange rate connects the flow of capital and goods
between countries. We continue with the case of the United States and Japan.
Suppose the United States wants to borrow more from Japan. Higher U.S. interest
rates will attract more Japanese investment to the United States. Japanese demand
for dollars increases at each exchange rate, shifting the demand curve for dollars
Thinking Like an Economist
NET EXPORTS AND THE EXCHANGE RATE
Incentives matter, and that is why the balance between exports
and imports is affected by the exchange rate. Consumers have
choices—for most goods, they can buy a brand produced in
the United States, or they can buy a brand produced abroad.
Similarly, firms may purchase the inputs they need for
production from domestic suppliers or from foreign suppliers.
In making choices, consumers and firms alike will respond
to the incentives provided by prices. If domestically produced
goods rise in price relative to foreign-produced goods, the
demand for the domestic goods will fall and the demand for
the foreign-produced goods will rise. The exchange rate affects
these decisions by affecting the relative prices of domestic
and foreign-produced goods.
If the dollar depreciates, it takes more dollars to buy
each unit of foreign currency. For example, in 2001, it cost
90 cents to buy one euro. Thus, any good or service with a
price of 100 euros would cost $90 to buy. By 2003, the dollar
had fallen in value relative to the euro, so that it cost $1.13 to
buy a euro. The same 100 euro good now cost an American
buyer $113, not $90. Because the dollar’s depreciation makes
the European-produced good more expensive, our imports
from Europe will tend to fall. From the perspective of a
European, however, American goods have become less expensive.
A U.S. good that sells for $100 cost 111 euros in 2001
(1 euro could buy $0.90, so it took 111 euros to buy the $100
U.S. good), but by 2003, that same $100 good cost only
88.5 euros.
What is important in determining the relative price of foreign
and domestic goods is the real exchange rate: the exchange
rate adjusted for changes in the general level of prices in different
countries. Suppose in our previous example that the
general price level in the United States had risen by 25 percent
between 2001 and 2003 so that instead of still costing
$100, the U.S. good had risen in price to $125 in 2003. Then,
to Europeans, the fall in the value of the dollar by 25 percent
(from $0.90 to $1.13 per euro) would just offset the rise in the
dollar price from $100 to $125: the good would still cost 111
euros. Similarly, from the perspective of the American consumer,
the good that cost 100 euros in 2001 costs $113 in 2003,
a 25 percent rise. Thus, its price has not changed relative to the
general level of U.S. prices—the real exchange rate would be
unchanged.
In fact, however, prices in the United States rose by only 4
percent between 2001 and 2003. Thus, the 25 percent depreciation
of the dollar more than offset that rise and represented
a large real depreciation in value. This will create incentives for
American consumers and firms to purchase fewer foreign
goods and services. Conversely, it will boost U.S. exports
by creating incentives for foreign consumers and firms to
purchase American products.
THE BASIC TRADE IDENTITY ∂ 579