[MUSIC] We've talked in abstract about what determines a value of the currency. And we've said that it's a very free market and supply and demand normally will move up or down and set the currency's value. And I know you're familiar with this tool if you've done previous economics classes. But a lot of times it helps us to just put it down, to be able to draw it. And I would encourage you to get some paper and draw this. Not only now, but as we continue to discuss currency values through this course, because visualizing it really helps. So let's just imagine here that we've got two supply and demand diagrams. One could be for US dollars, let's say. And one could be for the Indian rupee, okay? And for both of them, we would have a demand curve for the currency, okay, which is a down sloping curve. The idea is, as you know, if you've studied microeconomics, at a higher price for the currency people want less of it. At a lower price for the currency, people want more of it. So we have a downsloping demand curve as we do in almost every market. And then we have an upsloping supply curve in a free market, where the opposite happens, right? So here's our supply curve. And we could do the same for the Indian rupee, okay? Draw a demand curve, mark it with a D. Draw a supply curve, which I'm going to mark with an S. And in both of these markets, as you know if you use this tool, there is an equilibrium price, where those two curves meet one another. That equilibrium price, because we always put price on this axis, quantity on this one, okay? That equilibrium price will be the exchange rate for the currency, okay? Now, you will notice in this section, I'm not going to talk about exchange rates when we're moving, when we're doing the dynamic of currency movements. Because it's a little confusing. Sometimes it means that when I say the exchange rate went up, sometimes it means the currency went down. So I'm going to talk about the value of a currency rising or falling. I think that's very clear to everyone, okay? So this would be the equilibrium price of the currency. This would be the quantity of dollars that people wanted to buy and sell, okay? And now, if we're just thinking about the market for dollar-rupee exchanges, okay, there would be a corresponding supply and demand diagram over here. So, if we just think about exchanges, transactions between US dollars and Indian rupees, every time this moves, it would have an effect here, too, okay? So let's imagine for instance, that in the United States, the interest rate is raised, as has happened recently in the United States. If we think of those different determinants that we talked about just a moment ago, more people would want to buy US bonds. Because the interest rate on them is higher, and actually they are lending their money to the US government, aren't they? So they're interested in a higher interest rate. This would cause the demand for US dollars to rise. And that those would be, let's assume those are Indians buying US dollars, right? The demand for US dollars rises, therefore, the currency rises in value. At the same time, they are supplying Indian rupees to buy those dollars. So we could expect that the additional supply of rupees to the market would cause the rupee to fall. Now we often see this when interest rates change in one of the key economies. Of course the other currencies will fall because of this. And they'll fall because of this, okay? Another factor that could drive the value of a currency could be inflation rate differentials. When a country has a higher inflation rate, its currency tends to decline in value, okay? This is also has to do with, in part, this additional supply of the currency to the market. It also has to do with the fact that investors say, they've got a high interest rate, I think the currency will fall in value. So if we just think about the rupee, for instance, we might say with their high inflation rate, we would have an increased supply of rupees. We might also have a decrease demand for rupees. The value of the rupee would fall relative to the US dollar. So this is something you also want to watch. This is where often financial markets fixate on the inflation rate because it will tend to move the currency. Another factor that's important is trade itself. Now in the previous section, we talked about how when I export goods, they generate a demand for my currency, okay? When I import goods, they generate a supply of my currency. So you can imagine a situation where the United States has some very successful exports, okay? Imagine, and it's not the case as we'll see when get to the balance of payments. But imagine that the United States exports more than it imports, okay? That would mean that there would be a lot of demand for the US currency. And we would not be supplying so much additional currency to the market, okay? So, the overall effect would be to raise the value of the dollar. If on the other hand, we import more than we export, okay, then instead of this supply curve, which moved just a little, we would have demand moving. But let's move supply a lot more, you see? So we're supplying a lot more currency to the market to buy our imports. Then others are demanding to buy our exports. What's the net effect? Well, the dollar would fall, you see? So we find that in general, countries with large trade deficits tend to have declining currencies. Countries with trade surpluses tend to have rising currencies, all other things remaining equal. Couple of other factors, we've got the level of public debt, okay? If a country has a high public debt, all other things equal, there could be a tendency for investors to lose confidence in the country, okay? And this might mean that the demand curve for their currency, say rupees, would shift inward to the left. I don't want so many rupees because I don't want to buy Indian government bonds. Because I'm not sure that they can repay all of this. And so that could have an effect. And then finally, we can turn to stability. I'm going to show you some examples of this. But if a country experiences a political crisis, it looks unstable, we're not sure what's going to happen, often the demand for the currency will decline, okay? And therefore, the value of the currency will decline. On the other hand, for example, when Modi was elected in India, there was a surge in confidence in the country. And therefore, demand for the currency rose, because people wanted to use a currency to buy bonds, for example. And the currency rose in value. So these were just some examples of indicators that we watch for in the news to see in what direction a currency will tend to go in the future. [MUSIC]
