Predict Changes in the Euro–Dollar Exchange Rate
The demand–supply model predicts that the higher-inflation country’s currency will depreciate. Continuing with the U.S. and the Euro-zone example, if the U.S. has a higher inflation rate than that of the Euro-zone, the dollar is expected to depreciate against the euro.
When you work with the demand–supply model of exchange rate determination, first think about whether the relevant factor is related to trade or portfolio flows. Second, think about the people represented by the demand and supply curve and what they would do, given the nature of the change in one of the macroeconomic fundamentals.
Remember that inflation rate is a trade-related variable. If the U.S. inflation rate is higher than that of the Euro-zone, at the given exchange rate, European goods become less expensive to American consumers. Therefore, Americans are inclined to sell their dollars, buy euros, and buy European goods. This increases the supply of dollars in the market.
However, at the given exchange rate, American goods become more expensive to European consumers because of higher inflation rates in the U.S. Therefore, European consumers are now less inclined to buy American goods. Their demand for dollars decreases.
The figure shows that the dollar depreciates (and the euro appreciates) when the U.S. runs a higher inflation rate than the Euro-zone.