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).
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
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
InvestingForeign exchange risk is the chance that an investment’s value will decrease due to changes in currency exchange rates.
TradingIn general, higher interest rates in one country tend to increase the value of its currency.
TradingStruggling to get a grasp on exchange rates? Here's what you need to know.
TradingCurrency traders assess supply and demand, sentiment and market psychology, and technical factors to develop a big picture sense of the U.S. dollar’s flow.
InvestingSupply is the amount of goods a producer is willing to produce at a given price, and is one of the most basic concepts in economics.
InsightsMarket trends are shaped by larger economic factors, such as government influence, internal transactions, speculation and supply and demand.
InsightsTrends allow traders and investors to capture profits. Find out what's behind them.
TradingThe exchange rate is one of the most important determinants of a country's relative level of economic health and can impact your returns.