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2.5
2.0
1.5 Demand
for Euros
2.0
New
Demand
Demand
for Euros
100 200 300 Euros
Decrease in Domestic Income
$/Euro
2.0
Demand
New for Euros
Demand
100 200 300 Euros
Changes in Relative Prices
Assume prices for all goods rose in
Germany
If exchange rate did not change, then
prices of German goods in US would
increase
If US goods are competitive, then buyers
will substitute cheaper (US) goods for
more expensive (German) goods
Changes in Relative Prices
The substitution decreases demand for
Euros since fewer German goods are
being purchased
Demand for Euros would shift left with
fewer Euros demanded at every given
exchange rate.
The opposite is true for US prices rising
relative to German prices
Changes in Relative Prices
Price level changes are not this exact
Most countries experience continual price
changes and have differing amounts of
inflation
Countries with high levels of inflation relative
to trading partners will see more increase in
demand for foreign goods and foreign
exchange
Leads to depreciation of their currency over time
Supply of Foreign Exchange
Supply of currency in market comes as a
result of a countries demand for another
counties goods.
France wants to buy US products
They need US dollars to supply Euros for
dollars
France’s demand for dollars to buy US
goods effectively creates supply of Euros
Supply of Foreign Exchange
Example:
France wants to buy US Wheat
Price of wheat is $30/bushel
At 1.5 $/Euro, France supplies 20 Euro
At 2.0 $/Euro, France supplies 15 Euro
At 2.5 $/Euro, France supplies 12 Euro
At higher exchange rates, demand for wheat
is higher and quantity of Euro supplied is
higher – change in quantity supplied
Supply of Foreign Exchange
$/Euro
Supply
of Euros
2.5
2.0
1.5
2.0
1.5
2.0
1.5
2.0
1.5 Demand
for Euros
2.0 New
Demand
1.5 Demand
for Euros
3.0 Supply
of Euros
2.5
2.0 New
Demand
1.5
Demand
for Euros