19.1 Graphing Exercise: Flexible Exchange Rates

International trade in goods and services requires the exchange of currencies as well. The exchange rate, which measures the dollar price of one unit of a foreign currency, links all U.S. prices with the prices in the foreign country. This allows citizens of both countries to determine the relative prices of goods and services between the two countries. Under a system of flexible exchange rates, market forces determine the price of one currency relative to the other. An increase in demand for the foreign currency will cause its price to rise (the dollar depreciates) while an increase in the supply of the foreign currency will cause its price to fall (the dollar appreciates).

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Exploration: What are the determinants of exchange rates?

The market for Japanese yen is shown in the graph. The price is measured in the number of U.S. dollars required to purchase one Japanese yen. Use the interactive graph to predict the movement in exchange rates caused by changes in the determinants of supply and demand. Click on the label of the appropriate curve and drag it to a new location to shift either demand or supply; click on the New Equilibrium to observe the market adjustments necessary to restore equilibrium. Click Restore to begin a new question.

1. Suppose the U.S. enters a recession. What will happen to the dollar price of a yen?
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2. Suppose the expansion of Disney's theme park in California causes a large influx of Japanese tourists into the U.S. What will happen to the dollar price of a yen?
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3. How will the exchange rate be affected if the U.S. experiences a severe inflation while Japan's prices remain stable?
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4. Fearing a recession, the chair of the U.S. Federal Reserve Bank moves to lower domestic interest rates. How will this affect the price of a yen?
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5. Currency speculators anticipate the U.S. Federal Reserve Bank will likely lower interest rates in the future. What will happen to the dollar price of a yen?
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6. Suppose a change in preferences for Japanese goods increases the demand for yen. What will happen to the equilibrium price of yen? Does the dollar appreciate or depreciate? How might the U.S. government intervene in this market if it wished to maintain the price of yen at its previous level?
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