Explain and show graphically how an increase in incomes in the United States will affect equilibrium in the foreign exchange market?
An increase in incomes in the United States raises U.S. residents’ demand for goods and services, including imports. To buy more foreign goods, U.S. residents need more foreign currency. This increases the demand for foreign currency in the foreign exchange market. In a standard supply-and-demand diagram for a foreign currency (price expressed in USD per unit of foreign currency):
Step 1: Higher U.S. incomes → greater demand for imports.
Step 2: Greater import demand → increased demand for foreign currency (shift of the demand curve for foreign currency to the right).
Step 3: With the foreign-currency supply roughly unchanged in the short run, the increased demand raises the price of foreign currency (it appreciates) and the dollar depreciates.
Step 4: New equilibrium has a higher exchange rate (more USD per unit of foreign currency) and a larger quantity of foreign currency traded.
Graph: Demand for foreign currency shifts right from D₀ to D₁ due to higher U.S. incomes. With supply (S) unchanged, the foreign currency’s price in USD rises (foreign currency appreciates) and the dollar depreciates.
Note: This is the short-run effect. In the longer run, other adjustments (changes in foreign incomes, interest rates, or responses in supply) can modify the outcome.
Leave a Reply