Exchange rates and supply and demand

Like any other free floating market, currency rates in the foreign exchange market are also governed by supply and demand. In an increasingly globalized world, most people in a country are directly or indirectly involved in the forex markets as a result of goods and/or service between manufacturers and retailers.

The 4 basic laws of supply and demand say that

1. If demand increases and supply remains unchanged then price increases.

2. If demand decreases and supply remains the same then price goes down.

3. If supply increases and demand remains unchanged then price goes down.

4. If supply decreases and demand remains the same then price increases.

Currency Demand

Let's use the normal downward sloping demand curve graph to measure the price of the pound-USD exchange rate-on the vertical axis. Moving up on the vertical axis indicates an increase in price of the pound, which is equivalent to a fall in the price of the dollar. Similarly, movements down the vertical axis represent a decrease in the price of the pound.

At depreciated values for the pound, people in the US will switch from US-made goods and services to British-made. Before they can purchase goods made in Britain, they must exchange dollars for British pounds. Consequently, the increased demand for British goods is simultaneously an increase in the quantity of British pounds demanded.

Currency Supply

The supply curve slopes up because British firms and consumers are willing to buy a greater quantity of American goods as the dollar becomes cheaper (i.e. they receive more dollars per pound). Before British customers can buy American goods, however, they must first convert pounds into dollars, so the increase in the quantity of American goods demanded is simultaneously an increase in the quantity of foreign currency supplied to the United States.

Currency Equilibrium Price

Suppliers and consumers meet at a particular quantity and price at which they are both satisfied. This graph combines the supply and demand curves. The intersection determines the market exchange rate and the quantity of dollars supplied to United States. At the exchange rate R, the demand and supply of British pounds to the United States is Q.

This is known as the equilibrium or the market's clearing point.

An increase in the US demand for the pound (rightward shift of the demand curve) causes a rise in the exchange rate, an appreciation in the pound, and depreciation in the dollar. Conversely, a fall in demand would shift the demand curve left and lead to a falling pound and rising dollar. On the supply side, an increase in the supply of pounds to the US market (supply curve shifts right) as illustrated in the image below, where a new intersection for supply and demand occurs at a lower exchange rate and an appreciated dollar. A decrease in the supply of pounds shifts the curve leftward, causing the exchange rate to rise and the dollar to depreciate.

When the forces between supply and demand change, the market moves in ways to clear itself through a change in price.

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