Whether you know it or not, you have played a central role in determining your country's exchange rate. If you've ever purchased anything that came from another country, you have been a cog in the machine that goes into determining the price of another country's money relative to your country's money. Are you curious about how it all works? We invite you to keep reading.
Equilibrium exchange rate
When economists talk about equilibrium, it's just a short way for them to say that the forces of demand and supply have met at exactly the same place. The same price and the same quantity of something.
Therefore it should come as no shock that economists view the "price" of another countries' money as simply another thing that can reach equilibrium.
When thought of in this way, the equilibrium for the price of another country's money, or the exchange rate for that currency, is also the meeting point between demand for that country's money and supply for that country's money, relative to your country's money of course.
The equilibrium exchange rate is the exchange rate at which the quantity of a currency demanded is equal to the quantity supplied.
But what goes into the demand and supply of a country's money?
Before we go any further, let's make sure we agree on a few ideas.
First, we will call the place where people buy and sell currencies the "foreign exchange market." Second, we will agree that there are two ways to describe an exchange rate. The first way is by stating how much one unit of your currency can buy of a foreign currency, and the second is by stating how much one unit of a foreign currency can buy of your currency.
For simplicity, we will assume that there are only 2 countries in the world - Japan and the United States - and that you live in the United States. In addition, from now on we will define the U.S. exchange rate as the number of Japanese Yen one U.S. dollar can buy.
As of the writing of this explanation, 1 U.S. Dollar (USD) can buy 128 Japanese Yen (JPY), therefore the U.S. exchange rate is: 1 USD to 128 JPY.
We will also define how to describe changes in the value of one currency relative to another. If we stay with the USD and JPY example, if the value of 1 USD increased from 128 JPY to 130 JPY, we say that the USD has appreciated. Conversely, if 1 USD decreases value relative to the JPY from 128 JPY to 126 JPY, we say that the USD has depreciated.
When the value of a currency relative to another currency increases, we say it has appreciated.
When the value of a currency relative to another currency decreases, we say it has depreciated.
Equilibrium Exchange Rate Formula
You are probably looking here to find the equilibrium exchange rate formula...
but there isn't one!
As the equilibrium exchange rate is the exchange rate at which the quantity of a currency demanded is equal to the quantity supplied, then just like in a regular market, the demand and supply will need to be estimated, but here it can be done by using the balance of payments data. The equilibrium point would then be found where the sum of the balance of payments on the current account plus the balance of payments on the capital and financial account is zero.
Meaning of Equilibrium Exchange Rate
In order to really understand the meaning of an Equilibrium Exchange Rate, we must first understand what determines the demand and the supply of a currency. In this case, let's discuss what might impact the supply and demand for USD and JPY.
In this two-country world, you can only buy USD by selling JPY, and you can only buy JPY by selling USD. Stated another way, since you can only buy and sell a currency by exchanging it for another currency, when you buy JPY, you can only do so by providing, or selling USD, and when you buy USD, you can only do so by providing, or selling JPY.
As a result, the demand for USD occurs when someone needs to acquire something in USD (in exchange for JPY), and the supply of USD occurs when someone needs to acquire something in JPY (in exchange for USD), and vice versa.
Now, how do economists talk about why or when people would need one currency in exchange for another?
They do so by categorizing the exchange of currencies in terms of the transactions between them. In our two-country example, we will define this as the flow of goods, services, and financial assets between the U.S. and Japan, and we will call it the Balance of Payments.
The summary of one country's transactions with another country is called the Balance of Payments.
The Balance of Payments consists of the Current Account and the Capital and Financial Account.
Balance of Payments
Why does the Balance of Payments matter with respect to the USD to JPY exchange rate? The reason is that the Balance of Payments comprises two key components: the Current Account and the Capital and Financial Account.
The Current Account 1. Net Exports (sales of goods and services from the U.S. to Japan, net of U.S. purchases imported from Japan) 2. Net Factor Income (investment income and employment income paid to American workers by people or organizations in Japan, net of investment income and employment income paid to workers in Japan by people or organizations in the U.S.) 3. Net Money Transfers (funds sent by foreign governments, organizations, or individuals to domestic residents, net of funds sent to the other country by the domestic government, organizations, or residents).
The Capital and Financial Account1. Sales of financial capital assets to foreign governments organizations, or people, net of purchases of foreign financial capital assets by the domestic government, organizations, or people.
Once again, for simplicity, we will only consider Exports and Imports (and not Factor Income or Transfers), and we will only consider asset sales and purchases by the U.S. and Japanese private sector (not those by the corresponding governments).
To learn more check our explanations on:
BOP: Current Account
BOP: The Capital and Financial Account (CFA)
Balance of payments accounts
Determinants of Equilibrium Exchange Rate
So what determines the demand for USD? Well, at the risk of stating the obvious, demand for USD occurs when people want to buy U.S. goods, services, and financial assets. In other words, since all U.S. goods, services, and financial assets are sold in USD, you need USD to buy them.
However, just as with anything, the more expensive the USD is, the less demand there will be for it. For example, assume you wanted a hamburger, and you had a spaceship that could take you between Japan and the U.S. instantaneously. Assume also that a hamburger costs $1 USD in the U.S. and ¥128 in Japan. If the USD to JPY exchange rate is 1 USD: 128 ¥, then a hamburger would cost the same in both countries.
However, what if the exchange rate was $1 USD to ¥200? In this case, you would be smart to want to buy Japanese hamburgers, because with $1, you could buy a hamburger in Japan and still have ¥72 left over. Since we need JPY to buy a hamburger in Japan, people will sell USD in exchange for JPY, thereby demanding less USD (and more JPY). You can see in this example that the more expensive the USD is, the less demand there will be for it with respect to buying goods, services, and financial assets.
Figure 1. Demand for USD, StudySmarter Originals
Demand for currency slopes downward because when Currency 1 becomes cheaper relative to Currency 2 (depreciates), that means that Country 1 goods, services, and financial assets become cheaper for Country 2, thereby increasing demand for Currency 1 in exchange for Currency 2.
Conversely, what determines the supply of USD? Well, since we know that the only way to buy JPY, is by selling (or supplying USD), the supply of USD occurs when people want to buy Japanese goods, services, and Financial Assets.
Let's stick with the hamburger example. Since we know that, if the USD to JPY exchange rate increases from ¥128 to ¥200, people will demand more Japanese hamburgers because they're relatively cheaper. In order to buy those Japanese hamburgers, people will need to supply, or sell USD, in exchange for JPY. Hence the supply of USD will increase.
As we can see in Figure 2, the supply of USD slopes upward and to then right in line with the reasoning we provided.
Figure 2. Supply for USD, StudySmarter Originals
Supply for currency slopes upward because when Currency 1 becomes more expensive relative to Currency 2 (appreciates), that means that Country 2 goods, services, and financial assets become cheaper for Country 1 thereby increasing supply for Currency 1 in exchange for Currency 2.
Equilibrium Exchange Rate Example
Now that we understand the forces that generate the supply and demand for USD, all we need to do is bring them together to understand how we can achieve the equilibrium exchange rate.
Now instead of hamburgers, let's consider a more realistic example. We know that the exports and imports of a country's goods and services are one of the key determinants of the Balance of Payments between countries. We also know that the purchase of financial assets is another key component of the Balance of Payments between countries.
Therefore, let's consider the impact changes in exchange rates can have on exports, imports, and the purchase of financial assets. Let's stick with our two country example.
If the value of USD increases relative to the JPY, or appreciates, that means U.S. goods, services, and assets become more expensive to Japanese residents, thereby driving demand for those goods, services, and assets down.
At the same time, if the value of USD increases relative to the JPY, that means the value of JPY decreases relative to the USD, or depreciates, making Japanese goods, services, and assets cheaper to buy for U.S. residents, and drives demand for Japanese goods, services, and assets in the U.S. up.
At the equilibrium exchange rate, the sum of the balance of payments on the current account plus the balance of payments on the capital and financial account is zero.
Put another way, it's the exchange rate that ensures that the balance of payments between countries equals zero.
Equilibrium exchange rate graph
Let's analyze Figure 3 to better understand how and why equilibrium exchange rate occurs.
Let's assume that it's the first day of world trade, and neither the U.S., nor Japan have a solid understanding of how exchange rates work. In an effort to be able to sell goods, services, and assets to each other, they decide that a good starting exchange rate will be $1 USD to ¥200 JPY.
Let's also assume that hamburger trade is at the top of the import - export list because both countries make great hamburgers. Since we know that a hamburger in the U.S. costs $1 USD, and a hamburger in Japan costs ¥128 JPY, imports of Japanese hamburgers into the U.S. skyrocket because they're significantly cheaper than U.S. hamburgers. In other words, I can buy an imported Japanese hamburger for only $0.64USD since the cost of a Japanese Hamburger is only ¥128 JPY, and at the $1 USD to ¥200 JPY exchange rate, I only need $0.64 USD to get ¥128 JPY!
In order to import more Japanese hamburgers, U.S. residents need to acquire more Japanese Yen. This will increase the quantity demanded for JPY, and the only way to get JPY is by exchanging, or supplying USD. This can be seen as an upward movement along the Supply curve in Figure 3.
Similarly, since U.S. hamburgers are relatively expensive, Japanese resident stop buying them, thereby reducing the quantity demanded of USD. This is seen by the downward movement along the Demand curve.
When will the process of moving down the Demand curve and up the Supply curve stop? If you guessed "when the price of hamburgers are equal in both countries" then you guessed correctly!
The purchasing power parity (PPP) between two countries’ currencies is the exchange rate at which a given basket of goods and services would cost the same amount in each country.
Coincidentally, this is also the exchange rate required for the sum of the balance of payments between Japan and the U.S. to equal zero!
Figure 3. Equilibrium exchange rate through PPP, StudySmarter Originals
Shift in the demand curve for a currency
Now, what would happen if there was a shift in demand for USD?
Let's assume that the U.S. Government decided to increase interest rates. We know that one of the components of the demand for a currency includes that country's financial assets, and since a Government Bond is considered a financial asset whose return, or interest rate, has just increased, this would shift the demand for USD to the right as shown in Figure 4 below. In other words, demand for USD in the foreign exchange market increases as Japanese investors convert JPY into USD to buy more U.S. Bonds.
This is shown in Figure 4 by the shift of the demand curve from D0 to D1. At the current exchange rate of 1 USD for 128 JPY, there would be excess demand. The horizontal distance between points 1 and 2 shows excess demand. This excess demand would lead to the mechanism of bidding for USD at higher rates in order to acquire them, making the USD appreciate, ultimately establishing a new equilibrium point (Point 3) at an exchange rate of $1 USD to ¥150 JPY.
Figure 4. Demand shift for USD, StudySmarter Originals
Shift in the supply curve for a currency
Let's now consider a shift in supply for USD. What forces might shift the supply curve for a currency?
Let's assume the U.S. Government puts a quota on the import of Japanese hamburgers into the U.S. This has the effect of artificially limiting the quantity of Japanese hamburgers available for import into the U.S. Since there are less hamburgers available to import from Japan, less JPY are needed to buy the reduced quantity. Since less JPY are needed, less USD will need to be supplied at every exchange rate, and therefore supply of USD decreases.
This is shown in Figure 5 by the shift of the supply curve from S0 to S1. At the current exchange rate of 1 USD for 128 JPY, there would be a supply vacuum, or reduced supply. The horizontal distance between points 1 and 2 shows reduced supply. This reduced supply would lead to the mechanism of bidding for USD at higher rates in order to acquire them, making the USD appreciate, ultimately establishing a new equilibrium point (Point 3) at an exchange rate of $1 USD to ¥150 JPY.
Figure 5. Supply shift for USD, StudySmarter Originals
Government Policy Effects on Equilibrium Exchange Rates
Let's consider how government policies might impact the equilibrium exchange rate.
Government policies such as Fiscal Policy or Monetary Policy will definitely have an effect on equilibrium exchange rates but let's discuss why.
Assume the U.S. Central Bank decides to impose a Monetary Policy of increasing the interest rate. Since we know that demand for financial assets comprises one of the key flows between Japan and the U.S., and since U.S. Bonds are now more attractive because of the higher interest rate, or improved return, this will increase capital flows into the U.S., increasing the demand for USD. At the same time, USD capital flows out of the U.S. will decrease because U.S. bonds are more attractive to U.S. citizens as well, therefore reducing the supply of USD.
Since we know that these two effects will shift demand to the right, and shift supply to the left, other things being equal, an increase in a country’s interest rate will increase the value of its currency.
An increase in a country's interest rate will also result in an increase in its equilibrium exchange rate, all else being equal.
What if we consider a change in Fiscal Policy now?
Since the U.S. Government is also a consumer of goods and services, including imported goods and services, a change in Fiscal Policy can be as simple as Government buying fewer Japanese imports, thereby reducing the supply of USD. This will shift the USD supply curve to the left, and result in a higher USD equilibrium exchange rate.
Another way Governments can use fiscal policy to impact the equilibrium exchange rate is through taxation policy. Assume, for example, that the U.S. Government decides to decrease income taxes, such that all consumers now have more disposable income. With more disposable income come more purchases, including those of imported goods and services. As U.S. consumers purchase more Japanese goods and services, demand for the JPY will increase, thereby increasing the supply of USD, resulting in a rightward shift of the USD supply curve, and a lower USD equilibrium exchange rate.
A decrease in income tax rates in a country will result in a lower equilibrium exchange rate for that country's currency, all else being equal.
The Equilibrium Exchange Rate - Key takeaways
- The equilibrium exchange rate is the exchange rate at which the quantity of a currency demanded is equal to the quantity supplied. When the value of a currency relative to another currency increases, we say it has appreciated. When the value of a currency relative to another currency decreases, we say it has depreciated.
- Demand for currency slopes downward because when Currency 1 becomes cheaper relative to Currency 2 (depreciates), that means that Country 1 goods, services, and financial assets become cheaper for Country 2 thereby increasing demand for Currency 1 in exchange for Currency 2.
- Supply for currency slopes upward because when Currency 1 becomes more expensive relative to Currency 2 (appreciates), that means that Country 2 goods, services, and financial assets become cheaper for Country 1 thereby increasing supply for Currency 1 in exchange for Currency 2.
- At the equilibrium exchange rate, the sum of the balance of payments on the current account plus the balance of payments on the capital and financial account is zero. The purchasing power parity between two countries’ currencies is the exchange rate at which a given basket of goods and services would cost the same amount in each country.
- Changes in Monetary Policy such as an increase in a country's interest rate will also result in an increase in its equilibrium exchange rate, all else being equal. Changes in Fiscal Policy such as a decrease in income tax rates in a country will result in a lower equilibrium exchange rate for that country's currency, all else being equal.
Explanations 
Exams 
Magazine 
