Explain why individuals, businesses and governments buy or sell foreign currencies, describe how the foreign‑exchange market determines the exchange rate, and analyse the short‑term effects of exchange‑rate movements.
The Cambridge IGCSE syllabus identifies four main motives. Each creates either a demand for or a supply of foreign currency.
| Motive | Typical transaction | Effect on the market |
|---|---|---|
| Trade in goods & services (imports & exports) | Importers need foreign currency to pay overseas suppliers; exporters receive foreign currency when they sell abroad. | Imports → demand for foreign currency; Exports → supply of foreign currency. |
| Investment & profit flows (interest‑rate motive) | Foreign investors buy domestic assets (stocks, bonds) and need the home currency; domestic firms pay dividends, interest or profits to foreign shareholders. | Capital inflows → supply of foreign currency; profit/dividend payments abroad → demand for foreign currency. |
| Tourism, remittances and personal transfers | Travellers buy foreign currency before a holiday; migrant workers send money home (remittances). | Tourism & remittances → demand for foreign currency; receiving remittances → supply of foreign currency. |
| Speculation & government intervention | Speculators buy foreign currency expecting it to rise in value; central banks may buy or sell reserves to stabilise the rate. | Speculative buying → demand; speculative selling → supply; government purchases → supply, government sales → demand. |
The market works like any other price‑determination arena: the exchange rate adjusts until the quantity of a foreign currency that buyers wish to obtain equals the quantity that sellers are willing to provide.
The demand curve slopes downwards – a lower price (home‑currency appreciation) makes the foreign currency cheaper, encouraging more purchases.
| Factor | Reason for shift |
|---|---|
| Higher domestic income | More imports → greater need for foreign currency. |
| Higher relative price of domestic goods | Consumers switch to cheaper foreign goods. |
| Expectation that the home currency will depreciate | Buy foreign currency now to avoid a higher future price. |
| Increased tourism abroad | More travellers need foreign currency. |
| Government purchases of foreign reserves | Official demand for foreign currency. |
| Profit or dividend payments to foreign shareholders | Domestic firms convert home currency into foreign currency. |
| Factor | Reason for shift |
|---|---|
| Recession or fall in domestic income | Fewer imports. |
| Expectation that the home currency will appreciate | Delay purchases of foreign currency. |
| Reduced tourism abroad | Fewer travellers need foreign currency. |
| Government sale of foreign reserves | Official supply reduces private demand. |
The supply curve slopes upwards – a higher price (home‑currency depreciation) makes it more attractive for holders of the foreign currency to sell it.
| Factor | Reason for shift |
|---|---|
| Increase in domestic production for export | Exporters receive foreign currency. |
| Higher foreign interest rates | Foreign investors move capital into the home country, converting foreign currency into the home currency. |
| Expectation that the home currency will appreciate | Sell foreign currency now. |
| Remittances from abroad | Workers send money home, converting foreign currency. |
| Government sale of foreign reserves | Official increase in supply. |
| Factor | Reason for shift |
|---|---|
| Fall in export earnings | Less foreign currency earned. |
| Capital outflows (foreign investors selling domestic assets) | Domestic investors need to buy foreign currency. |
| Expectation that the home currency will depreciate | Hold foreign currency longer. |
| Government purchase of foreign reserves | Official reduction in supply. |
The equilibrium exchange rate, \(E^{*}\), is the price at which the quantity demanded equals the quantity supplied.
Mathematically:
\[ Q_D(E^{*}) = Q_S(E^{*}) \]At this point the market “clears” – there is no excess demand or excess supply.
| Shift | Typical syllabus cause | Resulting change in \(E\) |
|---|---|---|
| Demand curve shifts right (increase) | Higher domestic income, expectation of depreciation, larger tourism outflow, government buying reserves | Exchange rate rises → home currency **depreciates** |
| Demand curve shifts left (decrease) | Recession, expectation of appreciation, reduced tourism, government selling reserves | Exchange rate falls → home currency **appreciates** |
| Supply curve shifts right (increase) | Export boom, higher foreign interest rates, remittances, government selling reserves | Exchange rate falls → home currency **appreciates** |
| Supply curve shifts left (decrease) | Export decline, capital outflows, expectation of depreciation, government buying reserves | Exchange rate rises → home currency **depreciates** |
In the UK the demand and supply for US dollars are given by:
\[ Q_D = 500 - 20E \qquad\text{and}\qquad Q_S = 100 + 10E \]where \(Q\) is in millions of dollars and \(E\) is the exchange rate (£ per $1). To find the equilibrium rate:
Interpretation: At £13.33 per US$, the amount of dollars that UK residents want to buy equals the amount that UK exporters and investors are willing to sell.
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