EECS 1541 Lecture Notes - Lecture 40: Foreign Exchange Market, Pound Sterling, Demand Curve
24 Jun 2018
School
Course
Professor
EECS 1541 Lecture 40 Notes
Introduction
Change in the Equilibrium Exchange Rate
According to Exhibit 4.4, the equilibrium exchange rate is $1.55 because this rate
equates the quantity of pounds demanded with the supply of pounds for sale.
Changes in the demand and supply schedules of a currency force a change in the
equilibrium exchange rate in the foreign exchange market.
Before considering the factors that could cause changes in the demand and supply
schedules of a currency, it is important to understand the logic of how such changes
affect the equilibrium exchange rate.
There are four possible changes in market conditions that can affect this rate, and each
condition is explained with an application to the British pound.
The exchange rate varies because banks that serve as intermediaries in the foreign
exchange market adjust the price at which they are willing to buy or sell a particular
currency in the face of a sudden shortage or excess of that currency.
When reading the descriptions that follow, assume that a single bank accommodates all
customers seeking to buy British pounds (to exchange dollars for pounds)
As well as all who are looking to sell them (to exchange pounds for dollars).
This assumption makes it easier to understand why the exchange rate adjusts to shifts in
the demand or supply schedules for a particular currency.
Note that the bid/ask spread quoted by banks is not needed to explain this connection.
Increase in Demand Schedule
The U.S. demand for British pounds can change at any time.
Assume that the demand for British pounds in the foreign exchange market increases
(depicted graphically as an outward shift in the demand schedule) but that the supply
schedule of British pounds for sale has not changed.
Document Summary
According to exhibit 4. 4, the equilibrium exchange rate is . 55 because this rate equates the quantity of pounds demanded with the supply of pounds for sale. This assumption makes it easier to understand why the exchange rate adjusts to shifts in the demand or supply schedules for a particular currency. Note that the bid/ask spread quoted by banks is not needed to explain this connection. The u. s. demand for british pounds can change at any time. Assume that the demand for british pounds in the foreign exchange market increases (depicted graphically as an outward shift in the demand schedule) but that the supply schedule of british pounds for sale has not changed. Then the amount of pounds demanded in the foreign exchange market will be more than the amount for sale in the foreign exchange market at the prevailing price (exchange rate), resulting in a shortage of british pounds.
