Lecture 5 : Demand and

Supply
By Preeti Singh

The volume of international exchange has grown

tremendously since World War II
Whenever an exchange takes place between
residents of different countries, one kind of money
has to be exchanged for another
Foreign exchange rate between two currencies
is determined by supply and demand established
in the foreign exchange market consisting of a
network of foreign exchange dealers

Supply of and demand for foreign

exchange and foreign exchange rates.

What Determines Foreign

Exchange Rates
Imports of a country give rise to a demand
for foreign exchange and a supply of
U.S. dollars
Exports result in a supply of foreign
exchange and a demand for U.S. dollars
Therefore, trade of the U.S. will be a primary
contributor to the demand and supply of
dollars and foreign currency

 Balance of Payments
A summary of payments to foreigners for imports and
receipts from foreigners for exports

Current Accountinternational transactions

involving trade
Capital Accountinternational transactions
involving financial assets
Deficit

Paying out more abroad than we are taking in

(imports > exportstrade deficit)
Demand for foreign currency is greater than
supply
As a result, the price of foreign currency will
risethe foreign currency will appreciate
relative to the U.S. dollar and the U.S. dollar
will depreciate

 Balance of Payments
Surplus
Receiving more from abroad than we are
spending (exports > importstrade
surplus)
This will result in an appreciation of the
U.S. dollar and a depreciation of the
foreign currency
When exchange rates freely react to
supply and demand for foreign currency, a
new equilibrium exchange rate will tend to
eliminate balance of payments and bring
trade into balance (exports = imports)

 Balance of Payments
Deficit
Result in depreciation of the U.S. dollar
Encourages exports and discourages imports
Eventually the trade balance is in equilibrium
at the new exchange rate
Surplus
Appreciation of the U.S. dollar
Discourages exports and encourages imports
The trade will be balanced at the new
exchange rate

 Why Do Exchange Rates Fluctuate

The exchange rate between the U.S.
dollar and other major currencies varies
considerably over time
Anything that causes the demand or
supply in the foreign exchange market to
shift will change the equilibrium exchange
rate
U.S. residents buying more or less
foreign goods will shift the demand
curve for foreign currency
Changes in foreigners purchase of U.S.
goods will shift the supply curve of
foreign currency

A rightward shift in the demand curve for pesos

raises the dollar price of pesos, implying an
appreciation of the peso and a depreciation of the
dollar.

A rightward shift in the supply curve of pesos lowers

the dollar price of pesos, implying a depreciation of
the peso and an appreciation of the dollar.

 Factors that influence long-run

supply and demand conditions
Relative prices of U.S. versus
foreign goods
Relative increase in price of U.S. goods
will encourage more imports
increase
demand
for
foreign
currency
tends to depreciate the value of the
U.S. dollar or an appreciation of the
foreign currency
Relative decrease in price of U.S.
goods will result in an appreciation of
the U.S. dollar

Factors that influence long-run

supply and demand conditions
Productivity
Increased productivity in U.S. will lower price of
American goods
Increased demand for U.S. goods internationally
Increased supply of foreign currency will
appreciate the value of the dollar while foreign
currency depreciates
Tastes for U.S. versus foreign goods
Increased tastes for U.S. goods
Increased demand for U.S. goods and increased
supply of foreign currency
Dollar appreciates relative to foreign currency

International capital
mobility
Funds flow freely across international borders
and investors can purchase U.S. or foreign
securities
U.S. investors compare the expected return
on
domestic
securities
versus
foreign
securities to determine which are the most
attractive
Therefore, changes in preferences of U.S.
versus foreign securities will result in a change
in demand and supply of foreign currency and
a change in the exchange rate

 In this case, expectations of future

exchange rates play a central role in
the decision process
When considering investing in foreign
securities to take advantage of a
higher yield, must consider the
expected
movement
of
future
exchange rates
In order to invest in foreign securities,
must first purchase foreign currency
and eventually re-purchase U.S. dollars
to bring currency back to U.S.

 It is possible that a change in the future

exchange rate will offset any increased
yield by holding foreign securities
In fact, the international mobility of
capital will often cause the change in
future exchange rates that was
anticipatedself-fulfilling prophesy

How Global Investors Cause

Exchange Rate Volatility
This suggests that the equilibrium foreign
exchange rate is sensitive to investor
expectations of future movement in
exchange rates
Since these expectations might be quite
unstable and susceptible to change, this
may cause considerable short-term
volatility in the actual exchange rates