Question

Explain: "U.S. exports earn supplies of foreign currencies that Americans can use to finance imports." Indicate whether each of the following creates a demand for or a supply of European euros in foreign exchange markets: a. A U.S. airline firm purchases several Airbus planes assembled in France. b. A German automobile firm decides to build an assembly plant in South Carolina. c. A U.S. college student decides to spend a year studying at the Sorbonne in Paris. d. An Italian manufacturer ships machinery from one Italian port to another on a Liberian freighter. e. The U.S. economy grows faster than the French economy. f. A U.S. government bond held by a Spanish citizen matures, and the loan amount is paid back to that person. g. It is widely expected that the euro will depreciate in the near future.

Short answer

a. Demand for euros | b. Supply of euros | c. Demand for euros | d. No impact | e. Demand for euros | f. Supply of euros | g. Supply of euros

Step-by-step solution

Understand the Demand and Supply for Foreign Currency

In foreign exchange markets, demand for a currency is created when foreign entities need to buy goods, services, or assets from a country. Supply of a currency is created when domestic entities purchase foreign goods, services, or assets, requiring them to exchange their domestic currency for the foreign currency.

Evaluate Scenario a

A U.S. airline purchasing Airbus planes creates a demand for euros because the U.S. firm needs to exchange U.S. dollars for euros to pay for the planes made in France.

Evaluate Scenario b

A German automobile firm building a plant in South Carolina creates a supply of euros. The German firm needs U.S. dollars to invest in the U.S., so it sells euros to obtain dollars.

Evaluate Scenario c

A U.S. college student studying in Paris creates a demand for euros because they need to pay for tuition and living expenses in France using euros, exchanging U.S. dollars in return.

Evaluate Scenario d

An Italian manufacturer shipping machinery internally within Italy does not impact the demand or supply for euros in foreign markets, as the transaction is domestic.

Evaluate Scenario e

If the U.S. economy grows faster than the French economy, U.S. consumers are likely to import more from France, creating a demand for euros as they need them to pay for increased imports.

Evaluate Scenario f

A U.S. government bond maturing and being repaid to a Spanish citizen creates a supply of euros because the Spanish citizen receives U.S. dollars and exchanges them for euros.

Evaluate Scenario g

If it is expected that the euro will depreciate, people and businesses might rush to sell euros and buy other currencies, increasing the supply of euros in the market.

Key concepts

Demand for Currency

In foreign exchange markets, the concept of demand for a currency refers to the need for that currency in international trade and investment.
This demand is driven by various factors that require one nation to acquire another nation's currency. For instance, when a U.S. airline company buys Airbus planes from France, it must obtain euros because these transactions are conducted in the seller's currency. Therefore, the U.S. firm increases the demand for euros when exchanging dollars to complete the purchase.
Similarly, a U.S. student studying in Paris would need to exchange dollars for euros to cover tuition and living expenses, thereby increasing demand for the euro. Demand for a currency can surge due to:

• Purchasing foreign goods and services (imports).
• Investments in foreign assets.
• Tourism and education abroad.

Supply of Currency

The supply of a currency in foreign exchange markets reflects the availability of that currency being offered in exchange for other currencies.
This typically occurs when domestic entities purchase foreign products or assets, requiring them to sell their own currency. For example, if a German automobile company builds an assembly plant in the U.S., it would need U.S. dollars for the investment.
Therefore, they would sell euros to get the dollars, effectively increasing the euro's supply on the market. Another scenario is when U.S. government bonds mature and payments are made to foreign investors.
As these investors convert the received U.S. dollars into their own currency, they augment the supply of their domestic currency, in this case, euros. Key triggers for increased currency supply include:

• Investments in foreign lands (such as building plants or buying real estate).
• Selling domestic assets to foreign buyers.
• Payments of financial liabilities (like matured bonds).

U.S. Imports and Exports

The trade relationships between a country and its international partners heavily influence the dynamics of its currency demand and supply.
U.S. imports and exports significantly contribute to fluctuations in the foreign exchange markets through trading activities. When the U.S. imports goods and services, such as purchasing European cars or luxury items, it requires European currencies like the euro.
This increases demand for that currency, as domestic businesses and consumers must exchange dollars for euros. On the export front, U.S. businesses that sell goods overseas earn foreign currencies in return.
These foreign earnings can be used to finance further imports, demonstrating a continual flow of currency exchange. A faster-growing U.S. economy might see increased imports due to higher consumer spending power, resulting in a greater demand for euros. Thus, the interconnected nature of exports and imports plays a vital role in the currency flow across borders.

Currency Depreciation

Currency depreciation refers to a decrease in the value of a country's currency relative to other currencies in the foreign exchange market.
It can happen due to several factors, which may stimulate currency supply or impact economic expectations. If it is anticipated that the euro will depreciate, investors and businesses might rush to sell euros while its value is still relatively high.
This reaction increases the euro's supply as holders exchange it for more stable options like the U.S. dollar. Depreciation impacts numerous areas:

• It can make exports cheaper and more competitive globally.
• Conversely, imports become more expensive, potentially reducing demand for foreign goods.
• It can influence investment flows as investors seek higher returns from stronger currency holdings.

Understanding depreciation's economic effects helps businesses and finances adapt to changing market conditions.