Demand and Supply Shifts in Foreign Exchange Markets

Have you ever considered traveling abroad to a country where you can get a better value for your money? You might want to stock up on clothes or movies, or perhaps you could enjoy less expensive food? Why do you think this happens? In this article, you’ll discover how changes in foreign currency supply and demand affect your purchasing power.

Companies, households, and investors that purchase foreign goods, services, and assets (or who sell foreign goods, assets, and services to foreigners) participate in the foreign exchange market. In order to complete their transactions, they must therefore demand (or supply) foreign currencies. Households, for example, purchase imported goods that require foreign exchange. The same applies to wealthy individuals or businesses making investments abroad for which they require foreign currency as well.

Foreign exchange rates are determined by the foreign currency markets, where foreign exchange rates are determined. This rate is influenced by a variety of factors, including imports and exports, the GDP and market expectations. In the event of a decline in GDP in one nation, the nation is likely to import less. The economy will import more if its GDP grows. In addition to causing a shift in foreign exchange markets, these fluctuations also affect everything else. An economic crisis in the United States will cause the GDP to drop, which will reduce Mexico’s exports. Due to this, the American dollar depreciates against the Mexican peso, and demand for Mexican pesos decreases. Therefore, the peso increases in value.

Differences across Countries in Rates of Return

Foreign or domestic, investment is conducted for the purpose of earning a profit. It makes sense that a country with relatively high returns would attract foreign funds. In contrast, if rates of return in a country appear to be relatively low, then funds are likely to migrate elsewhere. Changing expected return rates will affect currency supply and demand.

For example, if the GDP falls in one nation, that nation is likely to import less. If GDP grows, it will import more. Everything else held constant, these fluctuations also cause a shift in foreign exchange markets. For example, if the U.S. goes into a recession, then GDP falls and they would import less from Mexico. Thus, the demand for Mexican pesos decreases and the U.S. dollar falls relative to the Mexican peso. In other words, the peso gains value.

Relative Inflation

During years of high inflation, a country’s currency loses its buying power, which makes decision-makers less likely to want to acquire or hold that currency.

Mexico experienced a 200% inflation rate between 1986 and 1987. Because of the dramatic decline in purchasing power of the peso in Mexico caused by inflation, the exchange rate of the peso declined as well. It illustrates the decrease in demand on foreign exchange markets for the peso from D0 to D1, while the increase in supply from S0 to S1. According to the new equilibrium exchange rate (E1), $2.50 per peso fell to $0.50 per peso from the original equilibrium (E0). Despite the volatility in the exchange rate, pesos continued to trade on the foreign exchange market.

Purchasing Power Parity

It is important that exchange rates be related to the purchasing power of a currency in international trade over the long term. In the event that international trade goods-such as oil, steel, computers, and cars-were much more affordable in one country than in another, businesses would begin importing from the cheap country, selling to another, and pocketing the profits.

The Canadian dollar is worth $1.60 for a dollar that sells for $20,000 in the United States. As a result, a car selling for $20,000 in the United States would be worth $32,000 in Canada. Some Americans buying cars in Canada would convert their dollars to Canadian dollars if domestic car prices were much lower than $32,000.

At least some buyers from Canada would convert the Canadian dollars to U.S. dollars and purchase their cars in the United States if the price of cars was much higher than $32,000 in this example. In arbitrage, goods and currencies are bought and sold across international borders for a profit. It could take time, but eventually exchange rates and prices will align, resulting in a comparable price for items traded internationally across all countries.

In purchasing power parity (PPP) exchange rates, the prices of internationally traded goods are equalized across countries. Based on detailed studies of the prices and quantities of internationally traded goods, economists at the International Comparison Program operated by the World Bank evaluated the PPP exchange rate for all countries.

Final words

Speculators who are attempting to invest in stronger currencies and sell weaker currencies influence exchange rates in the very short run, between a few minutes and a few weeks. The possibility of an expected appreciation leading to a stronger currency can create a self-fulfilling prophecy, at least for a time. Differences in return rates on investment affect exchange rate markets in the relatively short run. When countries have relatively high real rates of return (for example, high interest rates), their currencies will tend to be stronger as money from abroad is attracted, whereas countries with relatively low real rates of return will experience weaker exchange rates as investors convert their money to other currencies.

Markets for exchange rates are influenced by inflation rates in the medium run, within a few months and a few years. Inflation-prone countries have a tendency to experience lower demand for their currency than inflation-free countries, resulting in a depreciation of their currency. As currencies adjust over long periods, they tend to move towards purchasing power parity (PPP), which is an exchange rate that ensures that prices of internationally traded goods in different countries are equal in a common currency when the PPP exchange rate is applied.