Question

Upon reading in the newspaper that the dollar exchange rate with the euro has depreciated 12% in the last month, after a 15% appreciation in the previous month, one of your friends tells you, “I don’t understand a thing about these currency fluctuations. Surely the market must be irrational. Nothing justifies such large movements up and down.” What is your response?

Answer 1

The dollar versus euro exchange rate in the market is determined by the demand and supply of the dollar vis-s-is the euro in the market for dollar or the market for euro.

When the dollar exchange rate with the euro depreciated by 12% it implied that the dollar value fell possibly due to a decrease in demand for dollar or an increase in the supply of dollar.

This can be contrasted with a dollar appreciation of 15% with the euro whch resukts from an increase in demand for dollar or a fall in the supply of dollar.

Thus, the exchange rate market is not irrational. It is moving in response to the demand and supply.