Demand in the Foreign Exchange Market
The main factors that influence the dollars that people plan to buy in the foreign exchange market are the exchange rate, world demand for U.S. exports, interest rates in the United States and other countries, and the expected future exchange rate.
The law of demand in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the smaller is the quantity of dollars demanded in the foreign exchange market. There are two reasons for the law of demand:
Exports Effect: Dollars are used to buy U.S. exports. The lower the exchange rate, with everything else the same, the cheaper are U.S. exports so the greater the quantity of dollars demanded on the foreign exchange market to pay for the exports.
Expected Profit Effect: The lower the exchange rate, with everything else the same (including the expected future exchange rate), the larger the expected profit from buying dollars so the greater the quantity of dollars demanded on the foreign exchange market.
The law of demand means that the demand curve for U.S. dollars is downward sloping, as illustrated in the figure below.
Supply in the Foreign Exchange Market
The main factors that influence the dollars that people plan to sell in the foreign exchange market are the exchange rate, U.S. demand for imports, interest rates in the United States and other countries, and the expected future exchange rate.
The law of supply in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the greater is the quantity of dollars supplied in the foreign exchange market. There are two reasons for the law of supply:
Imports Effect: Dollars are used to buy U.S. imports. The higher the exchange rate, with everything else the same, the cheaper are foreign produced imports so the greater the quantity of dollars supplied on the foreign exchange market to buy these imports.
Expected Profit Effect: The higher the exchange rate, with everything else the same (including the expected future exchange rate), the smaller the expected profit from holding dollars so the larger the quantity of dollars supplied on the foreign exchange market.
The law of supply means that the supply curve for U.S. dollars is upward sloping, as shown in the figure.
Market
Equilibrium
Demand and supply in the foreign exchange market determine the exchange rate. In the figure, the equilibrium exchange rate is 100 yen per dollar, where the demand and supply curves intersect.
If the exchange rate is higher than the equilibrium exchange rate, a surplus of dollars drives the exchange rate down.
If the exchange rate is lower than the equilibrium exchange rate, a shortage of dollars drives the exchange rate up.
The market is pulled to the equilibrium exchange rate at which there is neither a shortage nor a surplus.
Exchange Rate Fluctuations
Changes in the Demand for U.S. Dollars
A change in any relevant factor other than the exchange rate changes the demand for dollars and shifts the demand curve for dollars.
World Demand for U.S. Exports: An increase in the world demand for U.S. exports increases the demand for U.S. dollars because U.S. producers must be paid in U.S. dollars. The demand curve for U.S. dollars shifts rightward.
U.S. Interest Rate Differential: The U.S. interest rate differential is the U.S. interest rate minus the foreign interest rate. The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the greater is the demand for U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the demand curve for U.S. dollars rightward.
Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the demand for U.S. dollars increases and the demand curve shifts rightward.