ECON 204: Intermediate Macro, Spring 2020, Dr.

Duggan
In-Class Exercise: What Determines the Movement of Floating Exchange Rates

Remember: More Yen per $ is a stronger dollar, an appreciation of the US currency

and a depreciation of the Yen.

We imagine two countries, Rest of World (ROW) and Home.

A. Shifts in Demand for a Currency

1) Demand by ROW for home’s exports shifts demand for its currency to the right.
2) Demand by ROW for home’s financial assets shifts the demand curve for its
currency to the right.
3) Demand by ROW for factories inside home (called FDI) increases the demand for
a country’s currency.

B. Shifts in Supply of a Currency

If home want to buy from ROW, home will have to offer its currency for sale to get the
currency of ROW.

1) Demand for ROW country’s imports by home citizens increases the supply of
home currency in the international market for $.
2) Demand for ROW country’s stocks and bonds by home citizens increases the
supply of home currency in the market for $.
3) Purchases of physical assets like factories overseas in ROW by home citizens ),
increases the supply of home currency in the world market.

Hint 1: When GDP rises in home country, imports from ROW country rise, too (see B1).
The idea is that as you get wealthier you start to spend more of your money on luxuries
and many luxuries are imports—like German Mercedes, Italian prosciutto, South African
Diamonds.

Hint 2: When inflation rises in home, ROW stops buying home’s exports. This is rising
prices in home mean ROW now has to pay more to get one unit of a good.

Hint 3: When interest rates rise in a home, ROW wants buy home’s financial assets (see
A2). Wealthy members of ROW feel that the country with the highest interest rate is the
best place to park their money. As income inequality has grown, so has the amount of
this so-called “hot money” piled up by wealthy people around the world looking for the
highest interest rate.

For the following exercises, assume there are only two countries in the world, the United
States and ROW. The action mentioned will affect both the market for dollars and the
market for peso (which is the currency of ROW). On each diagram, one curve will shift.
Use the rules on the other side of this paper to draw the new curve, and also mark the old
and new exchange rates. If Americans demand more of a foreign currency, the SUPPLY
of dollars offered increases (shifts right). If foreigners demand more of US currency, the
Demand for $ rises).
(a) Americans buy machine tools made in ROW.
Market for Dollars

Yen/$
S

Number of $

(b) Jerome Powell decides to raise US interest rates (see Hint 3)

Market for Dollars

Yen/$
S

Number of $
 (c) American GDP grows faster than Japanese (see Hint 1) above).

Peso/$
S

Number of Yen

(d) Wall Street advises Americans to invest their money in ROW government debt
because it offers high interest rates. (below)

Yen/$
S

Number of $

(e)Wall Street changes its mind, and tells Americans to sell off ROW bonds because
the government there is likely to default on its debt.

Yen/$
S

Number of $