EXCHANGE RATE DETERMINATION: DEMAND FOR AND SUPPLY OF A CURRENCY
The foreign exchange value of a currency, say the dollar (or any other currency) is a price and therefore in the free market system, it is determined by the forces of demand and supply.
DEMAND FOR A CURRENCY
The demand for a currency is a derived demand. A commodity is said to have derived demand when that product is not demanded for its own sake, but to be used for something else. For example wood may be demanded for the purpose of building or manufacturing furniture and not for its own sake. Wood therefore has derived demand. Similarly, a currency is demanded for buying goods, services and financial assets. Increase in foreign demand for American goods and services would increase the demand for the dollar, for example.
Should the dollar depreciate, for example, American goods, services, and financial assets become less expensive to foreign residents. Foreign residents will expand their demand of the dollar to buy more American goods, services, and financial assets. The demand curve for the dollar therefore will show a negative relationship between the exchange rate (the price of the dollar) and the quantity of it demanded.
SUPPLY OF A CURRENCY
Like the demand for a currency, the supply of a currency also has a derived demand. If for example the Euro depreciates relative to the dollar (the dollar appreciates), there will be an increase in the quantity demanded of the Euro, in order to buy more European goods and services. As more Euros are purchased, the quantity of dollars supplied in the foreign exchange market increases. Thus, the supply curve of the dollar will slope upwards from left to right, showing a direct relationship between the price of the dollar and the quantity of it offered for sale.
The major determinants of supply of and demand for foreign currency in a domestic economy are: interest rate changes; trade and direct investment factors; and speculations. For trade and direct investment, rise in domestic inflation will mean foreign goods will become relatively cheaper. There domestic demand for foreign currency increases as a result. Foreign inflation however, means domestic commodities will be become relatively cheaper. This increases the supply of foreign currencies to enable purchase of domestic goods. If expectation for future growth of the foreign economy is high, domestic demand for foreign currency increases for purposes of outward direct investment. On the other hand, if there is increased potential for domestic growth, foreign investment is attracted into the domestic economy and the supply of foreign currency increases.
A reduction in the domestic interest rate or a rise in the foreign interest rate will mean potential for capital gains when investment is undertaken in the foreign economy. Domestic demand for foreign currency will rise as a result. However, an increase in domestic interest rate or a decline in the foreign interest rate will lead to increase in the supply of foreign currency. Expectations of future drop in the value of the domestic currency or a future rise in the value of the foreign currency will lead to increases in domestic demand for foreign currency.
The foreign exchange market is in equilibrium when the quantity supplied of a currency is equal to the quantity demanded. When this is the case, there is neither excess demand nor excess supply of currency and this is the market clearing exchange rate.
For further reading, see the following books and journals.
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