Global Economic Analysis - International Finance

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. Personal Finance

    Top 10 Most Valuable Sports Teams in 2015

    Cleats, pads and profits: we take a look at the top 10 most valuable sports teams in the world.
  2. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  3. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  4. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  5. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  6. Professionals

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  7. Taxes

    3 Secrets You Didn't Know About Estate Planning

    Every advisor and saver needs to know these three estate planning secrets.
  8. Professionals

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  9. Entrepreneurship

    10 Ways to Nurse Cash Flow in Healthcare

    Running a business in healthcare? You might want to rethink cash flow management practices.
  10. Professionals

    How to Help Clients with Cash Flow Issues

    Sometimes your spending gets out of hand or income has a hiccup. Here's how financial advisors can help clients who have cash flow issues.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!