4.5.2 Changes in Demand and Supply of a Currency Notes

We have already mentioned that the demand and supply for a currency fluctuate to determine its exchange rate. Now let us look at the main factors that affect changes in demand and supply:

1. Foreign demand for exports
2. Domestic demand for imports
3. Inward/Outward foreign direct investment (FDI)
4. Inward/Outward portfolio investment
5. Remittances
6. Speculation
7. Relative inflation rates
8. Relative interest rates
9. Relative growth rates
10. Central bank intervention

Foreign Demand for Exports

1. Imagine that country X exports a good to country Y.
2. When consumers in country Y buy that good, it may seem like they pay in their local currency, but in reality a currency exchange takes place.
3. The payment involves converting country Y’s currency into country X’s currency.
4. This means consumers in country Y are effectively supplying (selling) their currency to buy country X’s currency.
5. As a result, the currency of country X appreciates because of the increased demand for it.

Domestic Demand For Imports

1. Now put yourself in the shoes of a consumer from country Y.
2. Country X has exported goods to your country, and you decide to buy some of these imports.
3. When the purchase is made and the hidden currency exchange occurs, the effect on country Y’s currency is:
   1. A depreciation, since the supply of country Y’s currency increases as more imports are purchased.

Inward/Outward Foreign Direct Investment(FDI)

Inward

1. If an investor from country Y makes a foreign direct investment in country X, the investment must be carried out in the local currency of country X.
2. As a result:
   1. The demand for country X’s currency will increase.
   2. The currency of country X will appreciate.

Outward

1. If an investor from country Y makes a foreign direct investment in country X, it will result in:
   1. An increase in the supply of country Y’s currency.
   2. A depreciation of country Y’s currency.

Inward/Outward Portfolio Investment

• Portfolio Investment has the same effect on exchange rates as the FDI.

Remittances