6.3 Supply and Demand for Foreign Exchange

The Foreign Exchange Market

The foreign exchange (forex) market is where currencies are traded. Demand for a currency comes from foreigners wanting to buy that country's goods, services, or assets. Supply of a currency comes from domestic residents wanting to buy foreign goods, services, or assets. The equilibrium exchange rate is set where currency supply and demand curves intersect, like any market.

Shifters of Currency Demand and Supply

Demand for a currency (e.g., dollars) increases when foreigners want more U.S. exports, U.S. assets, or higher U.S. interest rates (relative returns). Supply of dollars increases when Americans want more imports or foreign assets. Changes in relative income, relative price levels, relative interest rates, and preferences shift these curves, appreciating or depreciating the currency.

Appreciation vs. Depreciation

When demand for a currency rises or supply falls, the currency appreciates (buys more foreign currency). When demand falls or supply rises, it depreciates. A stronger (appreciated) currency makes exports pricier and imports cheaper abroad; a weaker (depreciated) currency makes exports cheaper and imports pricier.

Key terms

Demand for a currency

Comes from foreigners wanting to buy that country's exports, services, or assets.

Supply of a currency

Comes from domestic residents wanting to buy foreign goods, services, or assets.

Appreciation

An increase in a currency's value relative to another currency, making it buy more foreign currency.

Depreciation

A decrease in a currency's value relative to another currency, making it buy less foreign currency.

Relative interest rates

Higher domestic interest rates (relative to abroad) attract foreign investment, increasing currency demand and causing appreciation.

Try an AP-style question

Foreigners wanting more U.S. goods will…

1. increase demand for dollars
2. increase supply of dollars
3. not affect dollars
4. decrease demand for dollars