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How Do Shifts in Demand and Supply Affect The Exchange Rate?

Equilibrium in the foreign exchange market occurs where the supply of and demand for currencies is equal. The equilibrium exchange rate is where surpluses and shortages are eliminated. Shifts in the supply and demand curves change the equilibrium exchange rate. Demand for a currency shifts right when its country's goods are in greater demand, investment there is more desirable, or speculation increases its future value. Demand shifts left in opposite scenarios. This causes the equilibrium exchange rate to rise or fall accordingly.

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61 views2 pages

How Do Shifts in Demand and Supply Affect The Exchange Rate?

Equilibrium in the foreign exchange market occurs where the supply of and demand for currencies is equal. The equilibrium exchange rate is where surpluses and shortages are eliminated. Shifts in the supply and demand curves change the equilibrium exchange rate. Demand for a currency shifts right when its country's goods are in greater demand, investment there is more desirable, or speculation increases its future value. Demand shifts left in opposite scenarios. This causes the equilibrium exchange rate to rise or fall accordingly.

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Difa
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© © All Rights Reserved
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As in any other market, equilibrium occurs in the foreign exchange market where the quantity

supplied equals the quantity demanded. In Figure 29-2, 4120 = $1 is the equilibrium exchange
rate. At exchange rates above Y120 = $1, there will be a surplus of dollars and downward
pressure on the exchange rate. The surplus and the downward pressure will not be eliminated
until the exchange rate falls to Y120 = $1. If the exchange rate is below Y120 = $1, there will be
a shortage of dollars and upward pressure on the exchange rate. The shortage and the upward
pressure will not be eliminated until the exchange rate rises to ¥120 = $1. Surpluses and
shortages in the foreign exchange market are eliminated very quickly because the volume of
trading in major currencies such as the dollar and the yen is very large, and currency traders are
linked together by computer.
Currency appreciation occurs when the market value of a country's currency increases
relative to the value of another country's currency. Currency depreciation occurs when the
market value of a country's currency decreases relative to the value of another country's
currency.

How Do Shifts In Demand And Supply Affect The Exchange Rate?


Shifts in the demand and supply curves cause the equilibrium exchange rate to change. Three
main factors cause the demand and supply curves in the foreign exchange market to shift:
1. Changes in the demand for U.S.-produced goods and services and changes in the demand
for foreign-produced goods and services
2. Changes in the desire to invest in Red States and changes in the desire to invest in foreign
countries
3. Changes in the expectations or other des out the likely future value of the dollar and the
likely future value of new currencies

Shifts in the Demand for Foreign Exchange Consider how the three factors listed above will
affect the demand for U.S. dollars in exchange for Japanese yen. During an economic expansion
in Japan, the incomes of Japanese households will rise, and the demand by Japanese consumers
and firms for U.S.goods will increase. At any given exchange rate, the demand for U.S. dollars
will increase, and the demand curve will shift to the right. Similarly, if interest rates in the United
States rise, the desirability of investing in U.S. financial assets will increase, and the demand
curve for dollars will also shift to the right. Some buyers and sellers in the foreign exchange
market are speculators. Speculators buy and sell foreign exchange in an attempt to profit from
changes in exchange rates. If a speculator becomes convinced that the value of the dollar is going
to rise relative to the value of the yen, the speculator will sell yen and buy dollars. If the current
exchange rate is ¥120 = $1, and the speculator is convinced that it will soon rise to ¥140 = $1,
the speculator could sell Y600,000,000 and receive $5,000,000 (= ¥600,000,000/¥120) in return.
If the speculator is correct and the value of the dollar rises against the yen to ¥140 = $1, the
speculator will be able to exchange $5,000,000 for 4700,000,000 (= $5,000,000 ¥140), leaving a
profit of ¥100,000,000.
To summarize, the demand curve for dollars shifts to the right when incomes in Japan
rise, when interest rates in the United States rise, or when speculators decide that the value of the
dollar will rise relative to the value of the yen.
During a recession in Japan, Japanese incomes will fall, reducing the demand for
U.S.-produced goods and services and shifting the demand curve for dollars to the left. Similarly,
if interest rates in the United States fall , the desirability of investing in U.S. financial assets will
decrease, and the demand curve for dollars will shift to the left. Finally, if speculators become
convinced that the future value of the dollar will be lower than its current value, the demand for
dollars will fall, and the demand curve will shift to the left.

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