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

sell in the foreign exchange market. As they do so, the supply of dollars will increase.
The equilibrium exchange rate is the value of dollars in terms of euros that balances
the demand for dollars and the supply of dollars. In the figure, e 0 is the equilibrium
exchange rate. At a lower exchange rate such as e 1 , the demand for dollars exceeds
the supply of dollars. Just as in the market for wheat, if demand exceeds supply, the
price will rise. In this case, the value of the dollar will rise. At an exchange rate such
as e 2 , supply exceeds demand and the dollar will fall in value.
Panels B and C illustrate the effects on the exchange rate of a shift in the supply
of dollars and the demand for dollars, respectively. In panel B, the supply curve has
shifted to the right, increasing the supply of dollars at each exchange rate. Perhaps
a change in European tax law has made investing in Europe more attractive to
American firms (other factors that might shift the supply curve will be discussed
below). At the initial exchange rate e 0 , there is now an excess supply of dollars. The
dollar will fall in value until the new equilibrium is reached at the exchange rate e 1 .
Panel C illustrates another change in the foreign exchange market—this time a
shift to the left in the demand curve for dollars, reflecting a smaller demand for dollars
at each exchange rate. Such a shift might be caused by a change in U.S. tax law
that makes it less attractive for European firms to invest in the United States. At
the initial exchange rate e 0 , there is now an excess supply of dollars. The value
of the dollar falls until the new equilibrium is reached at the exchange rate e 1 . At
this lower value, the demand for dollars and the supply of dollars are again equal.
Earlier, we noted three reasons why Europeans might wish to sell euros to buy
dollars and, conversely, Americans might wish to sell dollars to buy euros. We can
now discuss how each of these factors affects demand and supply in the foreign
exchange market.
Exports and Imports Consider what happens if a U.S. firm sells a product in
Europe. Suppose, for example, Levi Strauss sells jeans in Europe. The company can
do three things with the euros it receives for the goods it has sold. First, it could try
to convert them into dollars. Second, it could sell the euros to an American firm
EXCHANGE RATE =
EURO/U.S. DOLLAR (e)
e 2
e 0
e 1
A
Supply curve
for dollars
Demand curve
for dollars
EXCHANGE RATE (e)
e 0
e 1
S
S'
B
Supply
curves
Demand
curve
EXCHANGE RATE (e)
e 0
e 1
C
Demand
curves
Supply
curve
D
D'
U.S. DOLLARS U.S. DOLLARS U.S. DOLLARS
Figure 34.1
THE EXCHANGE RATE
In equilibrium, the exchange rate is determined where the demand for dollars equals the
supply, as in panel A. A rightward shift in the supply curve of dollars (panel B) or a leftward
shift in the demand curve for dollars (panel C) results in a lower exchange rate; that
is, the dollar depreciates.
760 ∂ CHAPTER 34 THE INTERNATIONAL FINANCIAL SYSTEM