The demand for and supply of a currency

Published by Patrick Mutisya · 14 days ago

IGCSE Economics 0455 – International Trade and Globalisation: Foreign Exchange Rates

International Trade and Globalisation – Foreign Exchange Rates

Objective

Understand the determinants of the demand for and supply of a foreign currency and how these affect the exchange rate.

Key Concepts

  • Exchange rate: the price of one currency expressed in terms of another.

  • Demand for a currency: the amount of that currency that buyers wish to obtain at various exchange rates.

  • Supply of a currency: the amount of that currency that sellers are willing to provide at various exchange rates.

Demand for a Currency

The demand curve for a foreign currency slopes downwards because, as the price of the foreign currency falls (i.e., the home currency appreciates), it becomes cheaper for domestic residents to buy the foreign currency.

Suggested diagram: Downward‑sloping demand curve for a foreign currency.

Factors that increase demand

FactorEffect on Demand
Increase in domestic incomeMore imports → higher demand for foreign currency
Higher relative price of domestic goodsConsumers switch to cheaper foreign goods → higher demand
Speculative expectations of depreciationInvestors buy foreign currency now to avoid loss → higher demand
Tourism outflowsTravel abroad requires foreign currency → higher demand

Supply of a Currency

The supply curve for a foreign currency slopes upwards because, as the price of the foreign currency rises (i.e., the home currency depreciates), holders of the foreign currency are more willing to sell it.

Suggested diagram: Upward‑sloping supply curve for a foreign currency.

Factors that increase supply

FactorEffect on Supply
Increase in domestic production for exportExporters receive foreign currency → higher supply
Higher foreign interest ratesForeign investors move capital into the home country, converting foreign currency → higher supply
Speculative expectations of appreciationInvestors sell foreign currency now to buy it later at a higher price → higher supply
Remittances from abroadWorkers send money home, converting foreign currency → higher supply

Equilibrium Exchange Rate

The equilibrium exchange rate (\$E^*\$) is where the quantity of the foreign currency demanded equals the quantity supplied.

\$E^* : \; QD(E^*) = QS(E^*)\$

At this point the market clears; there is no excess demand or excess supply.

Shifts in the Curves

  1. Demand shift right (increase): caused by higher domestic income or expectations of depreciation. Result – higher equilibrium exchange rate (currency depreciates).

  2. Demand shift left (decrease): caused by recession or expectations of appreciation. Result – lower equilibrium exchange rate (currency appreciates).

  3. Supply shift right (increase): caused by a boom in exports or higher foreign interest rates. Result – lower equilibrium exchange rate (currency appreciates).

  4. Supply shift left (decrease): caused by a fall in exports or capital outflows. Result – higher equilibrium exchange rate (currency depreciates).

Suggested diagram: Simultaneous shifts in demand and supply and the resulting new equilibrium exchange rate.

Numerical Example

Suppose the demand and supply for the US dollar (USD) in the UK are given by:

\$Q_D = 500 - 20E\$

\$Q_S = 100 + 10E\$

where \$Q\$ is measured in millions of dollars and \$E\$ is the exchange rate (£ per $1). Find the equilibrium exchange rate.

Set \$QD = QS\$:

\$500 - 20E = 100 + 10E\$

\$400 = 30E\$

\$E^* = \frac{400}{30} \approx 13.33\;£/\\$$

Interpretation: At £13.33 per dollar, the quantity of dollars demanded equals the quantity supplied.

Summary

  • Demand for a currency is driven by imports, tourism, speculation, and income levels.

  • Supply of a currency is driven by exports, foreign investment, remittances, and speculation.

  • Changes in any of these factors shift the respective curve, altering the equilibrium exchange rate.

  • Understanding these movements helps explain short‑term exchange‑rate volatility and informs policy decisions.