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

The foreign exchange market in Yerevan, Armenia
SUPPLY AND DEMAND IN THE FOREIGN
EXCHANGE MARKET
In competitive markets, prices are determined by demand and supply. Similarly,
exchange rates are determined by demand and supply in foreign exchange markets.
In our example of just two currencies—dollars and euros—it makes no difference
whether we look at things from the perspective of the demand for and supply of dollars
or from the perspective of the demand for and supply of euros. The European
supply of euros on the foreign exchange market is equivalent to the European’s demand
for dollars. The U.S. supply of dollars is equivalent to Americans’ demand for euros.
Panel A of Figure 34.1 shows supply and demand curves in the foreign exchange
market. The horizontal axis measures the volume of dollars; the vertical axis measures
the exchange rate, the value of the dollars in terms of euros. We express the
value of the dollar as the number of euros it takes to buy 1 dollar in the foreign
exchange market. Thus, if the exchange rate is 2 euros to the dollar, the dollar is
expensive in terms of euros—it takes 2 euros to buy 1 dollar. If the exchange rate is
one half a euro to the dollar, the dollar is cheap—it only takes a half a euro to buy 1
dollar (or, equivalently, 1 euro will buy 2 dollars). The higher the exchange rate, the
more expensive the dollar is in terms of euros.
The demand for dollars has been drawn as a downward sloping curve. As the
exchange rate falls, dollars become cheaper. Just as demand for a good goes up when
its price falls, so, as dollars become cheaper, Europeans will want to purchase more
of them.
The supply curve of dollars has been drawn in the figure with a positive slope. As
the exchange rate rises, Americans will be able to get more euros for every dollar they
DETERMINING THE EXCHANGE RATE ∂ 759