Foreign Exchange Rates: Demand and Supply

This section explores the forces of demand and supply that determine the exchange rate between two currencies. Understanding these forces is crucial for analyzing international trade and globalization.

Understanding Exchange Rates

An exchange rate is the value of one currency expressed in terms of another. For example, the exchange rate between the British Pound (GBP) and the US Dollar (USD) might be 1 GBP = 1.25 USD. This means it costs 1.25 US Dollars to buy one British Pound.

Factors Influencing Demand for a Currency

The demand for a currency arises from various factors:

• Imports: When a country imports goods and services, its residents need to buy the foreign currency to pay for them. This increases the demand for the foreign currency.
• Foreign Investment: Investors need to buy a foreign currency to invest in assets (like stocks, bonds, or property) in that country. This increases the demand for the foreign currency.
• Tourism: Tourists visiting a country need to exchange their currency for the local currency. This increases the demand for the local currency.
• Speculation: Traders may buy a currency if they believe its value will increase in the future. This speculative demand can drive up the currency's value.

Factors Influencing Supply of a Currency

The supply of a currency occurs when individuals or entities need to convert their currency into a foreign currency:

• Exports: When a country exports goods and services, the foreign buyers pay in their own currency. The exporters then need to convert this foreign currency into their own currency, increasing the supply of the exporter's currency.
• Remittances: Migrant workers often send money back to their home countries. This increases the supply of the home country's currency.
• Foreign Aid: Receiving foreign aid means a country receives funds in a foreign currency, which they then need to convert into their own currency, increasing the supply of their currency.
• Speculation: Traders may sell a currency if they believe its value will decrease in the future. This speculative supply can drive down the currency's value.

The Market for Foreign Exchange

The exchange rate is determined by the interaction of supply and demand in the foreign exchange market. This is a global, decentralized market where currencies are traded.

Currency	Demand	Supply
GBP	Imports of goods and services from the UK	Exports of goods and services from the UK
USD	Imports of goods and services to the US	Exports of goods and services from the US
EUR	Imports of goods and services from the Eurozone	Exports of goods and services from the Eurozone

Impact of Changes in Demand and Supply

Changes in either the demand or supply of a currency will lead to a change in its exchange rate.

• Increase in Demand: If the demand for a currency increases (e.g., due to increased imports), its value will appreciate (become stronger).
• Decrease in Demand: If the demand for a currency decreases (e.g., due to decreased exports), its value will depreciate (become weaker).
• Increase in Supply: If the supply of a currency increases (e.g., due to increased exports), its value will depreciate.
• Decrease in Supply: If the supply of a currency decreases (e.g., due to decreased imports), its value will appreciate.

Example

Suppose there is an increase in demand for the Japanese Yen (JPY) because businesses in other countries want to buy Japanese cars. This increased demand will cause the value of the Yen to appreciate against other currencies.

Diagram

Conclusion

The exchange rate between two currencies is determined by the fundamental forces of supply and demand. Understanding the factors that influence these forces is essential for analyzing international trade and globalization, as exchange rate fluctuations can significantly impact the cost of imports and exports, and the competitiveness of a nation's economy.