MAcro CHAPTER 6.4:

CHAPTER SUMMARY

Demand for various currencies can shift for a few main reasons:

• Foreign Tastes & Preferences: If India becomes a more popular travel destination, demand for the Indian Rupee will increase because those tourists will need the currency to travel there.

• Trade Prices: If Japanese goods become more expensive, the quantity of Japanese goods demanded will fall, causing demand for the Japanese Yen to fall as well.

• Foreign Income Levels: When Chinese people get wealthier, they start to demand more imported goods, increasing demand for many foreign currencies.

• Interest Rates: Right now, real interest rates in Vietnam are much higher than in the United States, so I demand VND instead of USD so that I can collect higher interest. If interest rates in the United States went up, I might switch some of my money to USD, increasing demand for USD and decreasing demand for VND.

Supply can also be shifted for almost the exact same reasons, except we focus domestically instead. For example, if people in a country get wealthier or want to buy more foreign goods, they will start to supply more of their currency than before.

Now, get ready for one of the crazier parts of Macro. How can governments' fiscal policy impact exchange rates? There is a long chain of events. Let's see an example:

1. The US government increases spending

2. Aggregate Demand (AD) in the US increases

3. The USA's price level rises

4. People in foreign countries demand less American goods -> Demand for USD goes down

5. The US Dollar depreciates

The same sequence will generally occur any time the government engages in expansionary monetary or fiscal policy. Real GDP will rise, but the side effect is that the currency of the country depreciates. On the flip side, if the government engages in contractionary monetary or fiscal policy, Real GDP will fall, but the currency of the country should appreciate.

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