Any or all of these changes will cause the American demand for British pounds (the Euro) to

increase from DD to, say, D’D’in Figure 3. We observe that at the initial $1.5 = ￡1 exchange rate an

American balance of payments deficit has been created in the amount ab. That is, at the $1.5 = ￡1

rate there is a shortage of pounds in the amount ab to Americans. American export-type transactions

will earn xa pounds, but Americans will want xb pounds to finance import-type transactions.

Because this is a free competitive market, the shortage will change the exchange rate (the dollar

price of pounds) from $1.5 = ￡1 to, say, $2.25 = ￡1; that is, the dollar has depreciated.

At this point it must be emphasized that the exchange rate is a very special price which links all

Domestic (American, Russian, Japanese, etc.) prices with all foreign (Britain, European Union, Russia,

Japan, etc.) prices. A change in the exchange rate, therefore, alters the prices of all British

(European, Russian, Japanese, et,c.) goods to Americans and all American goods to potential buyers

In other countries. Specifically, this particular change in the exchange rate will alter the relative

Attractiveness of appropriate imports and exports in such a way as to restore equilibrium in the

Balance of payments of the country (nation).

In short, the free fluctuation of exchange rates in response to shifts in the supply of and demand