Exchange rates and their determination: A basic model
The international value of a country’s currency has become an inescapable part of the daily ﬂow of economic information. Most individuals are aware that a country’s exchange rate is important, but many of us do not have a clear idea of why the exchange rate matters or what causes it to change. As the chapter’s opening quote indicates, the familiar tools of supply and demand analysis can be used to determine a country’s exchange rate. In this chapter, you will learn why the supply and demand model works in analyzing exchange rates – in the same manner, in fact, that it works in analyzing the price of gasoline or pizza, for one dollar or one yen or one gallon of gasoline is indistinguishable from another. By the end of this chapter you should have a good grasp of why exchange rates are important and what factors cause them to change over the long run. Finally, it is obvious to even a casual observer that exchange rates change frequently. These changes, or volatility, are a source of aggravation for individuals, businesses, and governments. The chapter explains what economists know about the effects of exchange-rate volatility on international trade and how changes in exchange rates affect the prices of the goods and services we purchase. The ﬁnal part of the chapter deals with the underlying value of a currency. While the exchange rate we observe in the market often differs from that value, it is very useful to know what that value is.