Please answer the following questions about foreign exchange rates.
- How would each of the following be likely to affect the value of the dollar, all else equal?
- U.S. stocks are perceived as having become much riskier financial investments.
- European computer firms switch from U.S.-produced software to software produced in India, Israel, and other nations.
- As East Asian economies grow, international financial investors become aware of many new high-return investment opportunities in the region.
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In order to understand how to answer this question, you need to know what determines the exchange rate between two currencies. Basically, exchange rates (if they are allowed to float) are determined by supply and demand. When there is greater demand for a country’s currency, its value (all other things being equal) will rise. When there is a greater supply of a currency, its value falls. In general, there is demand for a currency when foreigners want to buy things (goods, services, or investments) from that country. There is a greater supply of a currency when people from that country want to buy other countries’ currencies. With this in mind, we can answer your questions.
In the first question, foreign investors have lost confidence in American stocks. This means they will not be buying as many of these securities. If they are not going to buy as many, they will not need as many dollars and the demand for dollars will drop. When this happens, the value of the dollar drops.
In the second scenario, foreign companies no longer want to buy American software. This means that the foreign companies will not need as many dollars (all other things being equal). When this happens, the demand for dollars and the value of the dollar drop.
In the third scenario, the value of the dollar drops as well. This can happen for two reasons. First, non-American investors might move their money out of American investments and into Asian ones. This will decrease the demand for dollars. Second, American investors might want to use dollars to buy Asian currencies so as to invest in Asia. This will increase the supply of dollars. In both cases, this will cause the value of the dollar to decline.
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