Inflation Abroad: The Dollar Appreciates
High inflation abroad makes US goods relatively cheap, foreign buyers demand more dollars to buy US exports, and the dollar appreciates.
Inflation Abroad: The Dollar Appreciates
Foreign Exchange Market (USD)High inflation abroad makes US goods relatively cheap, foreign buyers demand more dollars to buy US exports, and the dollar appreciates.
Equilibrium at Quantity of USD 80, Exchange Rate (foreign / USD) 1
Start at Equilibrium
The market for dollars begins where the demand for dollars (D$) equals the supply of dollars (S$). The exchange rate is the foreign currency price of one dollar.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
Inflation Abroad: The Dollar Appreciates, step by step
- 1
Start at Equilibrium
The market for dollars begins where the demand for dollars (D$) equals the supply of dollars (S$). The exchange rate is the foreign currency price of one dollar.
- 2
Prices Abroad Take Off
Inflation abroad runs far above US inflation, so foreign-made goods become expensive relative to American-made goods. Foreign buyers shift toward US exports, and every one of those purchases must be settled in dollars, so the demand for dollars shifts right. This is the mirror image of higher US inflation, which instead pushes Americans toward imports and shifts the supply of dollars right.
- 3
The Dollar Appreciates
At the new equilibrium the exchange rate is higher, so one dollar buys more foreign currency and the dollar has appreciated. The equilibrium quantity of dollars traded rises as foreigners convert more of their currency to buy US goods.
- 4
Read the Inflation Differential
What matters for the exchange rate is relative inflation, not the level in either country on its own. If both countries inflated at the same pace, relative prices would be unchanged and neither curve would move. Here foreign inflation is higher, so the dollar gains purchasing power against that currency and appreciates.
Where it ends up
Relatively cheaper US goods raise the demand for dollars, so the demand curve shifts right and the dollar appreciates while the quantity of dollars traded rises. Relative inflation is what moves the exchange rate, not the level in one country.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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