The influences on currency demand and supply

Overview

Effect of speculation on the exchange rate and how a country's political stability affects its exchange rate.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What creates the demand for a country's currency in the foreign exchange market?

   Model answer

   Demand for a currency arises from foreigners who need it in order to pay for something denominated in it. This includes foreign buyers of the country's exports of goods and services, including tourists visiting it, foreign investors buying its shares, bonds, property and businesses, foreign banks and firms placing deposits or lending in that currency, migrants remitting money into the country, and speculators who expect the currency to rise. Each of these has to buy the currency, so each is a source of demand.

2. 2

   What creates the supply of a country's currency in the foreign exchange market?

   Model answer

   Supply arises from residents who need foreign currency and must sell their own to obtain it. This includes importers paying foreign suppliers, residents travelling or studying abroad, residents buying foreign shares, bonds, property and businesses, firms sending profits or interest abroad, migrants remitting money out of the country, and speculators who expect the currency to fall. Each of these offers the domestic currency to the market.

3. 3

   Analyse the effect of a rise in the demand for a country's exports on its exchange rate.

   Model answer

   Foreign buyers must obtain the exporting country's currency to pay for the goods, so the demand curve for that currency shifts to the right. On a diagram with the exchange rate on the vertical axis and the quantity of the currency on the horizontal, the new demand curve intersects the unchanged supply curve at a higher exchange rate and a larger quantity traded. The currency therefore appreciates, which in turn makes the exports slightly dearer in foreign currency, partially offsetting the original increase in demand.

4. 4

   Analyse the effect of a rise in domestic demand for imports on the exchange rate.

   Model answer

   Residents must sell their own currency to buy the foreign currency needed to pay for imports, so the supply curve of the domestic currency shifts to the right. With demand unchanged, the intersection moves to a lower exchange rate and a larger quantity traded, so the currency depreciates. The depreciation then raises the domestic price of imports, which partly restrains the increase in import demand that caused it.

5. 5

   Analyse the effect of a rise in domestic interest rates relative to those abroad on the exchange rate.

   Model answer

   A higher relative return on domestic deposits and bonds makes them more attractive to foreign investors, who must buy the domestic currency in order to acquire them, so demand for the currency shifts right. Domestic investors also become less inclined to place funds abroad, so the supply of the currency to the market shifts left. Both movements raise the equilibrium exchange rate, so the currency appreciates. The effect can be very large and very rapid because the funds involved are mobile and the decision to move them requires no physical investment.

6. 6

   Explain what is meant by hot money and why it matters for the exchange rate.

   Model answer

   Hot money is short-term, highly mobile capital placed wherever it earns the best risk-adjusted return, moving between currencies at short notice. It matters because the sums involved dwarf trade flows, so a change in relative interest rates or in perceptions of risk can move a currency sharply within hours regardless of the underlying trade position. It also means a currency can be held up by inflows that could reverse suddenly, so an apparently stable rate can conceal a fragile position.

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