Exchange Rates and Supply and Demand

4.2 Supply and Demand

Prices of goods, commodities and exchange rates are determined on open markets under the
control of two forces, supply and demand.
The laws of supply and demand show that:

High supply causes low prices, and high demand causes high prices.
When there is an abundant supply of a given commodity then the price should fall.
When there is a scarce supply of a given commodity then the price should increase.
Therefore, an increase in the demand for a commodity would cause it to appreciate in
value, whereas an increase in supply would cause it to depreciate.

The value of a nations currency, under a floating exchange rate, is determined by the interaction
of supply and demand. We will work through some charts and an example to show how these
forces work, from a theoretical point of view.
Demand Curve

Figure 1 shows the demand for British pounds in the

United States. The curve is a normal downward sloping demand curve, indicating that as the
pound depreciates relative to the dollar, the quantity of pounds demanded by Americans
increases. Note that we are measuring the price of the pound-the exchange rate-on the vertical
axis. Since it is dollars per pound ($/), it is the price of a pound in terms of dollars and an
increase in the exchange rate, R, is a decline in the value of the dollar. In other words,
movements up the vertical axis represent an increase in price of the pound, which is equivalent to
a fall in the price of the dollar. Similarly, movements down the vertical axis represent a decrease
in the price of the pound.
For Americans, British goods are less expensive when the pound is cheaper and the dollar is
stronger. At depreciated values for the pound, Americans will switch from American-made or
third-party suppliers of goods and services to British suppliers. Before they can purchase goods

made in Britain, they must exchange dollars for British pounds. Consequently, the increased
demand for British goods is simultaneously an increase in the quantity of British pounds
demanded.
Supply Curve

Figure 2 shows the supply side of the picture. The

supply curve slopes up because British firms and consumers are willing to buy a greater quantity
of American goods as the dollar becomes cheaper (i.e. they receive more dollars per pound).
Before British customers can buy American goods, however, they must first convert pounds into
dollars, so the increase in the quantity of American goods demanded is simultaneously an
increase in the quantity of foreign currency supplied to the United States.
Equilibrium Price

Suppliers and consumers meet at a particular

quantity and price at which they are both satisfied. Figure 3 combines the supply and demand
curves. The intersection determines the market exchange rate and the quantity of dollars supplied
to United States. At the exchange rate R, the demand and supply of British pounds to the United
States is Q.
This is known as the equilibrium or the markets clearing point.
Changes in Demand and Supply

In figure 4, an increase in the US demand for the

pound (rightward shift of the demand curve) causes a rise in the exchange rate, an appreciation in
the pound, and a depreciation in the dollar. Conversely, a fall in demand would shift the demand
curve left and lead to a falling pound and rising dollar. On the supply side, an increase in the
supply of pounds to the US market (supply curve shifts right) is illustrated in Figure 5, where a
new intersection for supply and demand occurs at a lower exchange rate and an appreciated
dollar. A decrease in the supply of pounds shifts the curve leftward, causing the exchange rate to
rise and the dollar to depreciate.
Increase in Demand Increase in Supply

When the forces between supply and demand

change, the market moves in ways to clear itself through a change in price.
In international finance markets, if many investors are selling a particular currency, they are
making it more readily available and increasing its supply. If there is not an equal amount of
buyers, or demand, for that currency, its price will go down in order to strike a new balance
between supply and demand.
The direction in which the value of a currency is heading can cause cash to flow into or out of
that currency. A currency that is appreciating can cause money to flow into its countrys assets as
investors and Forex traders want to benefit from buying or taking long positions on the
currency as the currencys price rises.
There are many players that affect supply and demand for foreign currency exchange. Lets meet
them

4.3 Factors that Affect Supply and Demand

A variety of actors cause currencies to experience changes in supply and demand:

companies that export and import,

foreign investors and banks,
speculators who wish to engage in market activity,
and central banks that control the movement of interest rates.

Who Comprises the Forex market?

Due to its vast volume and large number of participants, no individual or single company has
complete control over which way the market will sway. Historically, Forex has been dominated
by commercial banks, money portfolio managers, money brokers, large corporations, and very
few private traders.
Lately this trend has changed. While there are many reasons for participating in foreign
exchange including facilitating commercial transactions, corporations converting its profits, or
hedging against future price drops, more and more people are getting involved in the market for
the purposes of speculation.
Exporting and Importing Companies

Large multinational corporations influence the foreign exchange market as they purchase and sell
goods and materials between different countries.

The first group that has influence in the foreign exchange markets is typified by large,
multinational corporations. Imagine a New York City firm exports its products to a German
company. The business transaction will be settled in dollars so the American firm obtains
revenue in its own currency and can pay its employees salaries in dollars.
To facilitate the transaction, the German firm needs to convert some of its capital from euros to
dollars on the foreign exchange market. The supply of euros increases leading to an appreciation
of the dollar and depreciation of the euro. It can also be said that the German firm increases the
demand for dollars, again causing the dollar to appreciate in comparison to the euro. This
transaction would have to be for a very large contract in order for the exchange rate to actually
move a pip up or down.

If the payment by the German company is coming 6 months later, it introduces the risk that the
amount of dollars they would receive for a certain amount of euros today will not be the same in
6 months time. A company may want to limit, or hedge, this exchange rate risk by immediately
converting their euro into dollars, or by purchasing forward contracts in the foreign exchange
market. A forward contract is a contract to convert euros into dollars at a future date at a set
price.
Importing companies affect the demand of a currency as well. For example, an American retailer
features Japanese furnishings and pays its suppliers in Japanese yen. If consumers like these
products then they will indirectly contribute to an increase in demand for the yen as the
American retailer will have to buy more merchandise from Japan. As the retailer purchases the
yen and sells the dollar on the exchange market, the yen appreciates.
Foreign Investment Flows

Foreign investment has many aspects, having to do with goods, services, stocks, bonds, or
property. Suppose a Canadian company wants to open a factory in America. In order to cover the
costs of the land, labor and capital the firm will need dollars. Suppose the company holds most
of its reserves in Canadian dollars. It must sell some of its Canadian dollars to buy US dollars.
The supply of Canadian dollars on the foreign exchange market will increase and the supply of
US dollars will decrease, which causes the US dollar to appreciate against the Canadian dollar.
On the flip side, foreign investors are also increasing or decreasing the demand for the currency
of the country in which they are interested in investing.
Banks

The Federal Reserve For a long time the foreign exchange

market has been associated with the term interbank market. This term was employed to capture
the nature of the foreign exchange market when it predominantly dealt with banks. Banks
included central banks, investment banks and commercial banks.

Examples of central banks include the Federal Reserve Bank of the United States or the
European Central Bank.
Investment banks include those of Goldman Sachs, JP Morgan, and Bank of America.
Today, banks are not the only participants within the foreign exchange market. With the
onset of technology and the growing ease of accessibility to market activity, there has
been an increase in many non bank participants such as individuals.

Speculators - Investment Management Firms, Hedge funds, and Retail Traders

Many financial institutions use currency exchange as a method to generate income. There are
also many individuals who try to do the same thing. The currency markets move in one direction
only when many investors act together. An individual investor cannot move the exchange rate of
a currency but many traders, investment funds, and banks may collectively move it.
If speculating traders think the Japanese Yen is going to weaken in the near future due to poor
economic data or a change in interest rate policy, then they sell the yen on the foreign exchange
market relative to another stronger currency. The supply of yen will increase and cause the
currency to depreciate. If many investors feel that a particular currency will depreciate in the
near future, their collective selling of that currency will move its price down. Similarly, if
speculators feel that a currency is going to appreciate in the near future then they will buy that
currency today and cause it to experience a higher demand which causes its price to go up.
Investors help materialize their predictions by acting in a herd mentality, and in some peoples
eyes bring about a self fulfilling prophecy.
On the next page we expand our discussion of central banks and their role in the financial
markets.

4.4 Central Banks

Floating vs. Fixed Exchange Rates

There are two types of exchange rate systems: floating or fixed. A floating exchange rate is one
in which a currencys value is determined by market forces. A fixed exchange rate matches,
pegs, the value of the currency to: one currency, several currencies or even to a fixed amount
of a commodity.
Floating Exchange Rates Prior to 1971s breakdown of the Bretton Woods Agreement (a fixed
exchange rate system revolving around the US Dollar and gold), most currencies were pegged.
Today, the current international financial system squares most of the currencies of the world
against one another in a free market. Floating exchange rates are preferable to fixed ones since
floating rates are reflective of market movement and the principles of supply and demand and
limit imbalances in the international financial system. Fixed exchange rates grant more control to
central banks (who may or may not be independent of the government) to set a currencys value,
and during times of volatility are preferred for their greater stability. Many developing countries
use fixed exchange rates in order to evade market abuse.
In extreme situations such as political unrest, terrorist attacks or natural disasters a countrys
currency may experience a period of heavy selling that causes it to depreciate in value. The
countrys central bank may intervene in order to restore the value of the currency. A central bank
regime that routinely intervenes would use the term "managed float". Sometimes, the central

bank may set upper and lower bounds known as price ceilings and floors, respectively, and
intervene whenever those bounds are reached.
Central Banks, Interventions, and Interest Rates

Central banks influence the supply and demand of their countrys currency through control of
interest rates or though intervention actions.
For many large economies, central banks can influence their currencys value by changing
interest rates. The US central bank, the Federal Reserve, is not necessarily trying to achieve a
weak or strong dollar policy, but acts in a manner that curbs inflationary pressure while
maintaining steady growth within the economy. It uses interest rates as a mechanism to achieve
this type of economic state. Our next lesson explains more about interest rates and central banks.

The other method used by banks to influence supply

and demand of its currency deals with directly buying or selling currencies through its reserves
(as was explained above). An example of such operation can be seen by the Reserve Bank of
China. Suppose the Reserve Bank of China thinks that the Chinese Yuan had appreciated too
much and wanted to lower its value. Then, the Reserve Bank of China will sell its yuan and buy
another currency such as the Japanese Yen into its reserves. The increased supply of yuan should
work to lower the yuans exchange rate.
Although this provides a convenient way for the central banks to control the value of their
currency, the banks must be careful. There is only a limited amount of currencies that each
country has within its reserves and a prolonged attempt to fight market forces can deplete it
causing a financial crisis.
A central bank can affect the demand for other countries currency as well. If the bank (Russian
Central Bank) feels that its reserve amount of a particular countrys currency (Euro) is too low
then it will engage in the foreign exchange market and buy that currency. This change in the
composition of the Russian central banks reserves, will lead to an increase in demand of the Euro
since it is being bought, and the Euros appreciation.
Lesson 5 explains the role of central banks in setting a countrys interest rates. It discusses the
effects that investment and inflation play in officials decisions. We will also give an example of
the Forex markets reaction to central banks actions and expectations.

.1 Interest Rates Importance to Forex

Interest rates play the most important role in moving the prices of
currencies in the foreign exchange market. As the institutions that set interest rates, central banks
are therefore the most influential actors. Interest rates dictate flows of investment. Since
currencies are the representations of a countrys economy, differences in interest rates affect the
relative worth of currencies in relation to one another. When central banks change interest rates
they cause the forex market to experience movement and volatility. In the realm of Forex
trading, accurate speculation of central banks actions can enhance the trader's chances for a
successful trade.
Interest Rates Dictate Investment

Interest rates can be simply defined as the amount of money a borrower must pay to a lender in
order to hold their money. In a simple representation of the foreign exchange market, the lender
is an investor holding cash or assets and the borrower is a bank inside a particular country. The
lender (investor) provides money to the borrower (the bank) and will receive, after a specific
time period, interest in conjunction with the original sum he or she put in. Typically, interest is
applied as an annual rate or percentage of the amount being lent. In forex trading interest is
credited on a daily basis.
A simple example:

A US investor, Jane, wants to place 100 dollars into a savings account with either a domestic or a
foreign bank. The US banks interest rate is 5.25%. In Japan, the interest rate for a savings
account is 0.25% and in New Zealand it is 7.25%. In considering the best investment after a year,
Jane can get back $105.25 investing in the US, $100.25 in Japan, and $107.25 in New Zealand.
Opening an account and lending money to a New Zealand bank is the investment option that
achieves the biggest return for Jane.
Janes investment decision shows that higher interest rates attract capital. As a result central
banks may attempt to draw foreign investment to their countries through higher interest rates.

How Interest Rates Play a Role in the Currency Markets

An increase in interest rates encourages traders to invest within that market and causes the
demand for the currency to rise. As demand rises, the currency becomes scarcer and
consequently more valuable. Investors are drawn to the currency, causing it to appreciate,
because they will gain a higher yield on their investments, as in the Jane example. In order to
purchase the country's assets (stocks or bonds), Jane will have to convert her domestic currency
to the target country's currency also increasing demand. Conversely, a fall in interest rates
dissuades investors from purchasing assets in that economy, as the return on their investment is
now smaller. The economy's currency will depreciate as a result of the weaker demand.

5.2 The Role of Central Banks

Central Banks Set Interest Rates

Since central banks, also known as reserve banks, play the crucial role of setting interest rates
they need to be followed and studied by a fundamental (and even technical) Forex trader. Central
banks want to achieve financial stability of their currency (i.e. battle inflation) and maintain
overall economic growth in their country. Their primary responsibility is to oversee the monetary
policy of a particular country or group of countries (in the case of the European Union).
Monetary policy refers to the various efforts made to effectively control and manage the amount
of money circulating within a nation. Skilled investors are able to properly identify which
currency will experience an increase in interest rates based upon a central banks statements and
incoming financial data. Those investors that are correct in their speculations can predict how the
respective currencies should move, and as a result should be able to take the proper long or short
positions.
Central Banks Role in Fighting Inflation

Central banks act in ways to lessen the effects of inflation on an economy. Inflation refers to a
rise in price levels which causes a fall in the purchasing power of a currency. Inflation accounts
for an entire basket of goods and services, not just an increase in the price of one item.

Monitoring prices of a particular basket is known as indexing and provides a reliable method of
tracking inflationary movement.
Inflations effects can be felt on just about everyone within a society regardless of whether one
engages in trading or not. At times of high inflation, employees will demand more money for
their work as the previous hourly wage no longer reflects the same value. In order to pay their
employees more, businesses have to raise their prices so that they can also manage to raise the
wages of its employees.

Inflation and Oil (Example)

Inflation Interestingly, inflation can be set off by the increase in price of just one crucial item
(food or energy) as well. An example of a volatile commodity that can cause inflation is oil. An
increase in the price of oil would cause many other items that use it as an input in the production
process (such as gasoline) to also increase in price and therefore begin the inflationary process.
Inflation poses a problem to the population because it erodes peoples wealth and standard of
living as their bank accounts and wages seem to diminish while prices get higher. The
purchasing power of the currency decreases and the currency loses strength. Therefore inflations
erosive nature necessitates the actions taken by the central bank.
Affects of Inflation on Interest Rates and Investment

If inflation is a concern then the central bank will raise interest rates to appease the inflationary
pressure. Higher interest rates will cause inflation to slow because it will cost more for
companies and consumers to borrow from banks to fund either investment spending or
consumption (i.e. for consumers it will be harder to refinance a mortgage on a house to free up
spending money). With more restrictive access to money, economic activity slows down and so
do inflationary pressures.
The higher interest rate will cause the currency to appreciate in the eyes of investors, both
domestic and foreign, as they will benefit from a higher yield on the country's assets. If the

currency is now appreciating relative to other currencies, then Forex traders will buy into it in
order to trade with the trend, sending even more money towards that economy.
It is therefore a delicate balance that central banks have to strike. They would like higher interest
rates to strengthen the currency and promote foreign investment, but they must be aware that
higher interest rates hurt domestic businesses and consumers that rely on borrowing money from
banks.
In the following pages, we shall look at an example of interest rates and central banks, and their
impact on the Forex market at work.

5.3 Market Reactions to Central Banks - FOMC Example

We will attempt to show how important interest rates are to

currency movements by examining price action on the Forex market during a recent central bank
tightening campaign. The following example focuses on the EUR/USD pair.
Lets investigate the implication of the United States Federal Reserves interest rate decisions to
the value of the US Dollar.
Dollar Gaining

EUR/USD - December 2004 - December 2006:

The Euro started 2005 at a high exchange rate, 1.3500 Dollars per Euro. US interest rates had
been hovering at very low rate of 1% prior to this time and the Euro was appreciating. In 2005,
on the other hand, there was steady Euro depreciation. The US central bank, the Federal Reserve,
continued a campaign, started in July 2005 to gradually raise interest rates from 1%. At every
subsequent meeting of the Federal Open Market Committee (FOMC), federal officials increased

the base interest rate by .25%. Financial markets reacted to this gradual hiking campaign by
favoring and strength ending the Dollar. When 2006 started, the EUR/USD pair traded around
1.2000, a change of 13 cents or 1300 pips. The central bank's actions were a major cause for the
Dollar appreciating in 2005.
Trend Reverses

EUR/USD - March 2005 - April 2006:

In December 05, at the 1.2000 level, the Euro finds support and begins to gain (second
rectangle). At this time investors are speculating that the Fed tightening campaign is likely
coming to an end. Similar speculation, and Euro appreciation, happened between July and
August 05 (first rectangle). In February the Feds base rate was raised to 4.50%. Speculation
that the Federal Reserve would finally pause after 15 straight rate hikes continued throughout
March and the first half of April, creating an upward trend favoring the Euro.

The Effect of Supply & Demand on the Rate

of Exchange
by Thomas Metcalf, Demand Media

Foreign exchange prices fluctuate based on the laws of supply and demand.
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The major determinants of exchange rates are the supply and demand for currencies. Exchange
rates rise and fall based on the underlying economic conditions that prompt traders, investors and
others to want more of a particular currency. Import and export companies, speculators, bankers

and central banks all have a need for buying currencies, and their interaction with each other
creates the supply and demand for foreign exchange.
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Supply and Demand

The supply of foreign exchange stems from foreign demand for U.S. dollars. When people or
businesses in another country wish to purchase American products, they purchase dollars with
their currency in order to have the dollars to buy the goods. Their increase in demand for dollars
will be matched by an increase in supply of their currency. A significant increase in the overseas
demand for US products will have the effect of driving up the value of the dollar vis-a-vis the
other currency. Until 1971, exchange rates were heavily controlled by central banks, but since
then they have floated, with very limited intervention from governments.

Determinants of Supply and Demand

There are numerous economic factors that determine the supply and demand for different
currencies. Economic changes that alter the relative strength of different countries are major
factors. The economic strength of the Japanese and German economies following World War II,
for example, was behind the appreciation of those currencies. Government debt is also a
contributing factor. If investors fear a country may default on its debt, they will drop their
investments and switch them to another currency. Interest rates also cause shifts in capital
accounts as investors move their assets from one currency to another, seeking higher returns.
Speculators look for opportunities in foreign exchange markets and can sometimes influence
price changes.
Related Reading: Finance Constraints of Agricultural Supply & Demand

The Foreign Exchange Market

Foreign exchange markets operate around the world six days a week. On Monday morning
(Sunday afternoon Eastern time) the foreign exchange market opens in Sydney, Australia.
Exchanges continue to open around the world as the day moves along. For the remainder of the
week there is a market open somewhere in the world until the U.S. markets close on Friday
afternoon -- by this time, it's already Saturday in areas like Sydney. The forces of supply and
demand operate between markets, assuring that the price of foreign exchange is equalized
market-to-market.

A Euro Price Movement Example

Suppose that the exchange rate for the euro is 1 euro = $1. If the U.S. economy drifts into
recession and interest rates fall along with the stock market, then Europeans will find U.S.
investments to be less desirable, while Americans will find European investments more
desirable. European demand for the dollar will fall at the same time American demand for the
euro increases. The shift of capital from American to European markets will cause the price of
euros to rise, creating a higher rate of exchange, which might be 1 euro = $1.35. It's all a matter
of supply and demand.