CFA Level 1

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.

Next: Purchasing Power Parity and Interest Rate Parity »


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