Law of Demand for Foreign Exchange
The law of demand for foreign exchange states that, all other factors remaining equal, the quantity demanded of a particular currency will decrease (increase) as the exchange rate goes higher (lower). Demand for a country's currency is derived from the goods or services produced by that country. The purchase of a Japanese car by an American consumer will necessitate the conversion of dollars to Japanese yen. As the exchange rate rises (in terms of Japanese yen), Japanese cars will become more expensive to American consumers, who will in turn buy fewer Japanese cars. The lower demand for Japanese cars will lead to a decreased demand for the yen. If the exchange rate for the yen vs. the dollar goes down, Japanese goods will be cheaper for American consumers. As a result, more Japanese goods will be purchased and more dollars will be exchanged for yen.

Law of Supply for Foreign Exchange
The law of supply for foreign exchange states that, all other factors remaining equal, the supplied quantity of a particular currency will increase (decrease) as the exchange rate goes higher (lower). U.S. citizens supply U.S. dollars to the foreign currency market when they buy foreign goods or services, or when they purchase foreign assets such as real estate or stocks. As the exchange rate increases (e.g. the price of a U.S. dollar in terms of Japanese yen goes from 100 yen per dollar to 110 yen per dollar), more U.S. dollars will be supplied as U.S. citizens get more value for their "buck".

Factors Affecting the Quantity of Demand and Supply for Currency
There are two main factors that affect the quantities demanded and supplied for a particular currency:

·Relative interest rates
·Expectations concerning future exchange rates

If, for example, interest rates in the United States are higher than those of other countries, foreigners will want to convert their currencies to dollars in order to earn a higher rate of return. Their actions will cause a reduction in the supply of dollars.

Expectations about future exchange rates will also impact current quantities demanded and supplied for currencies. For example, suppose the current exchange rate for euros and dollars is $1.20 per euro and an importer of European goods expects the euro to depreciate next month to $1.1 per euro. That importer will hold off on converting dollars to euros thereby decreasing the current quantity demanded for euros and the quantity supplied for dollars.

How is the Exchange Rate Influenced by Supply and Demand
If the demand for a currency increases (decreases) while the supply remains the same, the exchange rate will rise (decline) to achieve market equilibrium. If the supply of a currency increases (decreases) while demand remains the same, the exchange rate will decline (rise). Exchange rates can be volatile because supply and demand are affected by common factors, such as interest rate differentials and expectations.

Purchasing Power Parity and Interest Rate Parity

Related Articles
  1. Investing

    Explaining Foreign Exchange Risk

    Foreign exchange risk is the chance that an investment’s value will decrease due to changes in currency exchange rates.
  2. Insights

    Explaining Quantity Demanded

    Quantity demanded describes the total amount of goods or services that consumers demand at any given point in time.
  3. Trading

    6 Factors That Influence Exchange Rates

    An in depth look at out how a currency's relative value reflects a country's economic health and impacts your investment returns.
  4. Trading

    How Does The Yen Affect American Finance?

    Although it has fallen to number four on the trading partner list, Japan and its currency have a large impact on the American economy.
  5. Trading

    Interest Rate and Currency Value And Exchange Rate

    In general, higher interest rates in one country tend to increase the value of its currency.
  6. Investing

    Explaining Fixed Exchange Rates

    A government using a fixed exchange rate has linked the value of its currency to the value of another country’s currency, or the price of gold.
  7. Trading

    How to Calculate an Exchange Rate

    Struggling to get a grasp on exchange rates? Here's what you need to know.
  8. Trading

    The Pros & Cons Of A Strong Dollar

    As the U.S. economy has emerged from the Great Recession, the strength of the U.S. dollar has also improved.
Frequently Asked Questions
  1. What's the Best Way to Contact Warren Buffett?

    Learn how to contact Warren Buffett and what kinds of contact is most likely to receive a response from him or from his company, ...
  2. What is the Financial Services Sector?

    A diverse group of companies, beyond banks and credit unions, comprises the financial services sector.
  3. Who are Whole Foods' (WFM) main competitors?

    Whole Foods' main competitors are Sprouts Farmers Markets and Trader Joe's. However, the recent acquisition by Amazon my ...
  4. What caused the Stock Market Crash of 1929 that preceded the Great Depression?

    Find out what led to the stock market crash of 1929, which in turn led to the Great Depression. It sparked a nearly 90% loss ...
Trading Center