The Determination of the Exchange Rate

Let us look at the exchange rate of the British pound relative to the dollar. Based on the law of demand, as the price of pounds increases, the quantity demanded decreases, and as the price decreases, the quantity demanded rises. Suppose the exchange rate is £1 = $1 and a British sweater costs £100. Then the British sweater will cost $100, and Americans demand a certain quantity of sweaters. Now suppose the pound depreciates to £1 = $0.50. Then the price of the British sweater declines to $50. This reduction in the price of the British sweaters leads to an increase in the quantity demanded of sweaters by Americans and an increase in the quantity demanded of pounds.

The quantity supplied of pounds ...

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