Supply and Demand in the Foreign Exchange Market

When a German carmaker sells cars to American consumers, the consumers pay for the cars in U.S. dollars, but the German carmaker cares about how much it receives in euros, the official currency of the euro zone, which includes Germany. The German carmaker must use euros to pay its suppliers, employees, and shareholders. When an American buys a German car, the American pays in dollars, which the German carmaker uses to buy euros in the foreign exchange market (or FX market).

The FX market functions like other markets—there is a supply, a demand, and a market price. The supply consists of the currency being sold in the market, and demand is created as buyers purchase the currency in the market. And, as in other markets, as the forces of supply and demand shift, the price of currency in the FX market changes. In this case, the price is the exchange rate, which is the price of one country's currency in terms of another country's currency. When consumers and firms demand more U.S. dollars than previously, the increased demand for U.S. dollars will increase (or strengthen) its value in terms of euros. The increase in the supply of the euros that consumers and firms bring to the market will decrease (or weaken) its value relative to the U.S. dollar.

NOTE: Appreciation of the U.S. dollar relative to other major currencies.

SOURCE: FRED^®, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Trade Weighted U.S. Dollar Index: Major Currencies [DTWEXM]; Board of Governors of the Federal Reserve System; https://research.stlouisfed.org/fred2/series/DTWEXM/; accessed January 29, 2015.

Who Benefits and Who Is Hurt by Changing Currency Values?

Imagine you want to buy a German car here in the United States. The German carmaker must calculate the price to charge, based on its cost of production plus a markup. The carmaker pays these costs in euros (Germany's currency) and so cares about the price of the car in euros. Let's say that cost is 17,000 euros. American consumers, of course, care only about the price they pay in U.S. dollars, so the carmaker must set the price in U.S. dollars. Given a dollar-to-euro exchange rate of 0.7, the dollar price of the car would be $24,285.

Now imagine the dollar strengthens and the dollar-to-euro exchange rate increases to 0.8. (That is, instead of "buying" 0.7 euros with a dollar, you can now buy 0.8 euros with the same dollar.) At this point, the carmaker has a couple of options: It can keep the car's dollar price at $24,285, which would bring in 19,428 euros (up from 17,000), allowing the firm to earn higher profits. Or the German carmaker could hold the euro price at 17,000 euros and lower the price in U.S. dollars, which would decrease from $24,285 to $21,250, allowing the German carmaker to compete for U.S. customers at a lower dollar price without lowering its euro price. Or, it can make a little more money on each car while reducing the price to increase market share. In short, if the U.S. dollar strengthens relative to the euro, the German carmaker can either (i) keep the dollar price the same and earn a higher profit in euros or (ii) sell its cars at a lower dollar price, thereby gaining more U.S. customers. A price cut benefits the German carmaker and U.S. consumers, but it is bad for U.S. automakers that must compete with these lower prices.

It's important to realize that as the U.S. dollar strengthens relative to the euro, the euro weakens relative to the U.S. dollar. As a result, goods and services produced in the United States become relatively more expensive for foreign buyers, which hurts U.S. (domestic) producers that export goods. In short, a stronger U.S. dollar means that Americans can buy foreign goods more cheaply than before, but foreigners will find U.S. goods more expensive than before. This scenario will tend to increase imports, reduce exports, and make it more difficult for U.S. firms to compete on price.

So, who benefits and who is hurt by a weak dollar? A weaker U.S. dollar buys less foreign currency than it did previously. This makes goods and services (and assets) produced in foreign countries relatively more expensive for U.S. consumers, which means that U.S. producers that compete with imports will likely sell more goods (such as American cars) to U.S. consumers. A weaker dollar also makes U.S. goods and services (and assets) relatively less expensive for foreign buyers, which benefits U.S. producers that export goods. In short, a weaker dollar means that Americans will find foreign goods to be relatively more expensive than before, but foreign consumers will find U.S. goods less expensive than before. This scenario will tend to increase exports, reduce imports, and make goods and services produced by U.S. firms more attractive to American consumers.

Conclusion

The implications of words such as "strong" and "weak" can mislead people to believe that an appreciating currency is always better for the economy than a depreciating currency, but this is not the case. In fact, there is no simple connection between the strength of a country's currency and the strength of its economy. However, the value of the dollar relative to other currencies does affect individuals differently. Other things equal, a stronger dollar makes U.S. goods relatively more expensive for foreigners, which benefits U.S. consumers of foreign goods (imports) and hurts American exporters and American firms that might not export but do compete with imports. In addition, a weaker dollar makes foreign goods (imports) relatively more expensive for American consumers, which benefits exporters of U.S. goods and American firms that compete with imports.

Note

¹ Romer, Christina. "Needed: Plain Talk About the Dollar." New York Times, May 21, 2011; http://www.nytimes.com/2011/05/22/business/economy/22view.html?pagewanted=all&_r=0.

© 2015, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.