If the dollar depreciates vis-a-vis the pound, the pound appreciates vis-a-vis the dollar. Conversely,

If the dollar appreciates vis-a-vis the pound, the pound depreciates vis-a-vis the dollar.

What forces will cause the demand and supply curves for FCC to change and thereby cause the

dollar to appreciate or depreciate? Consider briefly some of the more important factors determining

exchange rates.

a) Changes in tastes. Any change in consumer tastes or preferences for the products of a foreign

country will alter the demand for or supply of that nation’s currency and change its exchange rate.

For example, if American and Japanese technological advances in computers make them more

attractive to European consumers and businesses, then they will supply more pounds and the Euro

In exchange markets in purchasing more American and Japanese computers, and the dollar and

yen will appreciate. Conversely, if British tweeds, French cosmetics become more fashionable in

the United States and Japan, the demand for pounds and the Euro will increase, and the dollar and

yen will depreciate.

b) Relative income changes. If the growth of a nation’s national income is more rapid than in

other countries, its currency is likely to depreciate. A country’s imports vary directly with its level

of income.

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c) Relative price changes. If the domestic price level rises rapidly, consumers will seek out relatively

low-priced import goods, thereby increasing the demand for the appropriate FCC, and conversely.

This combination of an increase in the demand for and a reduction in the supply of freely

convertible currency will cause the nation’s currency to depreciate.

d) Relative real interest rates. Suppose the United States restricts the growth of its money supply

(tight money policy), as was the case in the late 1970s and early 1980s, in order to control inflation.

As a result, real interest rates — money interest rates adjusted for the rate of inflation — were high

In the United States in comparison to most other nations. Consequently, British, German, Japanese

and other individuals and firms found the United States to be a very attractive place in which

to make financial investments. This increase in the demand for American financial assets meant an

Increase in the supply of British pounds, German marks, Japanese yen and others, and the dollar

therefore appreciated in value.

e) Speculation. Suppose it is widely anticipated that the European economy will (a) grow faster

than the American economy, (b) experience more rapid inflation than the American economy, and

(c) have lower future real interest rates than in the US. All these expectations would lead one to

believe that in the future the Euro will depreciate and, conversely, the dollar will appreciate. Hence,

holders of the Euro will attempt to convert them into dollars, increasing the demand for dollars.

This conversion, of course, causes the Euro to depreciate and the dollar to appreciate, because

speculators act on the supposition that these changes in currency values will probably happen.