Question

On October \(25,2000,\) the exchange rate was 0.8307 U.S. dollar per euro. It increased to 1.588 U.S. dollars per euro on July 16,2008 and then decreased to 1.0557 U.S. dollar per euro on March \(16,2015 .\) If the euro is expected to bounce back to its 2008 exchange rate, explain how this would affect the demand for and the supply of euros in the foreign exchange market?

Short answer

If the euro returns to the 2008 rate, demand for euros will decrease, and supply will increase.

Step-by-step solution

- Understand the Exchange Rate Changes

Identify the three key exchange rates provided: 0.8307 USD/euro on October 25, 2000, 1.588 USD/euro on July 16, 2008, and 1.0557 USD/euro on March 16, 2015. Note the increasing and then decreasing trend.

- Determine the Effect of Exchange Rate Changes

Recognize that an increase in the exchange rate (value of the euro) means that euros can buy more dollars. Conversely, a decrease means that euros can buy fewer dollars.

- Analyze Supply and Demand for Euros

Understand that if the exchange rate increases back to 1.588 USD/euro, the euro appreciates. This makes European goods more expensive for foreign buyers, potentially decreasing the demand for euros. Simultaneously, European consumers and businesses find foreign goods cheaper, increasing the supply of euros as they convert euros to USD to purchase these goods.

- Conclude the Impact on Market

Summarize that if the euro value returns to the 2008 rate, decreased demand for euros (due to more expensive European goods) paired with increased supply of euros (due to cheaper foreign goods) is expected.

Key concepts

Exchange Rate

An exchange rate is simply the price at which one currency can be exchanged for another.
Each country has its own currency, and the exchange rate allows us to determine how much of one currency you can get for another.
For example, if the exchange rate from euros to U.S. dollars is 1.588, it means 1 euro can be exchanged for 1.588 U.S. dollars.
Exchange rates fluctuate constantly due to various factors like economic stability, interest rates, and trade balances.
In the given exercise, we can see exchange rate changes over different years, showing how the value of the euro compared to the U.S. dollar increased and then decreased.

Currency Appreciation

Currency appreciation occurs when the value of one currency increases relative to another.
In the provided exercise, the euro appreciated from 0.8307 USD/euro in 2000 to 1.588 USD/euro in 2008. This meant the euro could buy more dollars over time.
When a currency appreciates, it can make goods from that country more expensive for foreign buyers.
This happens because the higher-valued currency (euro in this case) makes foreign goods cheaper, increasing imports and potentially decreasing exports.
Similarly, if the euro appreciates back to its 2008 rate, European goods would become more costly for international buyers.

Supply and Demand Dynamics

The foreign exchange market operates on the principles of supply and demand.
When the demand for euros increases, its value (exchange rate) typically goes up. Conversely, if more people want to sell euros, the supply increases and its value may decrease.
In the context of the given exchange rates, if the euro is expected to climb back to 1.588 USD/euro, it suggests several underlying supply and demand dynamics.
As the euro appreciates, European goods become pricier, reducing the demand for euros as fewer foreign buyers want to buy the more expensive products.
At the same time, the increased value of the euro means European buyers find foreign goods cheaper, thus converting euros into other currencies like the USD, thereby increasing the supply of euros.

International Trade

International trade involves the exchange of goods and services across countries, and the exchange rate plays a crucial role in this process.
When the euro appreciates, European exports can become less competitive since they become more expensive for foreign buyers.
On the other hand, imports into Europe become cheaper since Europeans get more foreign currency for their euros.
This shift impacts the balance of trade, which is the difference between a country’s exports and imports.
If the euro returns to its 2008 exchange rate, Europe may see a decrease in exports due to higher prices and an increase in imports due to more favorable exchange rates.
These dynamics directly affect the demand and supply for euros in the foreign exchange market, as outlined in the exercise.