Equilibrium Exchange Rate

Definition

The equilibrium exchange rate is the exchange rate at which the demand for a currency equals the supply of that currency in the foreign exchange market. It is the point where the forces of supply and demand balance out, resulting in a stable exchange rate between two currencies.

5 Must Know Facts For Your Next Test

1. The equilibrium exchange rate is the rate at which the quantity of a currency demanded equals the quantity supplied in the foreign exchange market.
2. Factors that can shift the demand and supply curves for a currency, and thus the equilibrium exchange rate, include changes in relative prices, interest rates, and trade balances between countries.
3. When the demand for a currency increases relative to its supply, the equilibrium exchange rate will rise, making the currency more valuable.
4. Conversely, when the supply of a currency increases relative to its demand, the equilibrium exchange rate will fall, making the currency less valuable.
5. The equilibrium exchange rate is an important concept in understanding the dynamics of international trade and the factors that influence exchange rate movements.

Review Questions

• Explain how changes in the demand for a currency can affect its equilibrium exchange rate.
  • If the demand for a currency increases relative to its supply, the equilibrium exchange rate for that currency will rise. This means the currency will become more valuable compared to other currencies. For example, if the demand for the U.S. dollar increases due to increased foreign investment in the U.S., the equilibrium exchange rate of the dollar will rise, making it more expensive to purchase with other currencies. Conversely, if the demand for a currency decreases, its equilibrium exchange rate will fall, making it less valuable.
• Describe how changes in the supply of a currency can influence its equilibrium exchange rate.
  • The supply of a currency is influenced by factors such as a country's trade balance, interest rates, and economic performance. If the supply of a currency increases relative to its demand, the equilibrium exchange rate will fall, making the currency less valuable. For example, if a country runs a large trade deficit, the supply of its currency on the foreign exchange market will increase, causing its equilibrium exchange rate to decrease. Alternatively, if a country's central bank increases the money supply, the increased supply of the currency will lead to a lower equilibrium exchange rate.
• Analyze how changes in relative prices between countries can affect the equilibrium exchange rate.
  • The relative prices of goods and services between countries can influence the demand and supply of currencies, and thus the equilibrium exchange rate. If the prices of goods and services in one country rise relative to another country, the demand for the currency of the country with higher prices will decrease, as its exports become more expensive. This will cause the equilibrium exchange rate of that currency to fall, making it less valuable compared to the currency of the country with lower relative prices. Conversely, if the prices in one country fall relative to another, the demand for its currency will increase, leading to a rise in its equilibrium exchange rate.

Related terms

Demand for Foreign Currency: The demand for a foreign currency is determined by factors such as the relative prices of goods and services, the interest rates, and the expectations of future exchange rate movements.

Supply of Foreign Currency: The supply of a foreign currency is influenced by factors like the relative prices of goods and services, the interest rates, and the trade balance between countries.

Foreign Exchange Market:

The foreign exchange market is the global marketplace where currencies are traded, and the exchange rates between them are determined based on the forces of supply and demand.