Currency Graphical Model

Foreign Exchange Rate Market Model

The role of trade and the product market

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Learning Objectives

The Exchange Rate Model is a descriptive graphical model of international exchange markets. The objective is to explain the slope of the supply function of foreign exchange. One expects supply functions to be upward sloping and this demonstration explains how events in the product market lead to this result

Assume there are only two countries (the US and the UK) and, two traded goods (the US exports levi's and the UK exports meat pies). All other assumptions from the previous models are the same. The supply curve for British pounds will be derived using the following assumptions:

  • no capital flows;
  • trade is the only source of exchange;
  • full repatriation of export earnings;
  • domestic and foreign product markets are competitive;
  • the elasticity of demand for the imported product exceeds unity.

The US domestic product market for the exported cloth (e.g. levi's) is competitive and the exporter is a price taker and cannot influence the domestic price of levis in the US. Also assume for the sake of simplicity the levi's are sold in the UK market without any mark-up or excess profit. Sales revenues (in British pounds) from the levi sales will be entirely repatriated (returned to the US) and form the only source of the supply of British currency in the foreign exchange market.

Imported
Product
Demand
Elasticity:
Domestic
Price of the
Exported
Product ($/levi)
Exchange
Rate
"A" $/£
Exchange
Rate
"B" $/£
Exchange
Rate
"C" $/£
Please Press

to see graph
...Select or change these parameters.
To produce a graphical scenario that reflects these exchange rates, be sure to click on the rectangular button to see results.

Three exchange rates are used to discuss the results. The elasticity of demand may be changed to see the impact on the supply of foreign exchange. Domestic product prices of levi's may be altered to analyse the effects in the exchange market.




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