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

1. When a relative sends remittance from country X to country Y:
   1. The supply of country X’s currency increases.
   2. The demand for country Y’s currency increases.
2. As a result:
   1. The currency of country X depreciates.
   2. The currency of country Y appreciates.

Speculation

1. When speculators expect a currency to appreciate in the future, they buy that currency at a lower price now to benefit from its later increase in value.
   1. As a result, the demand for that currency increases, causing it to appreciate.
2. Alternatively, if speculators expect a currency to depreciate, they sell it now at the highest possible price.
   1. As a result, the supply of that currency increases, causing it to depreciate.

Relative Inflation Rates

1. If country X experiences a lower rate of inflation than country Y, consumers in country Y can buy more goods from country X with the same amount of money.
   1. This increases the demand for country X’s exports.
   2. As a result, the currency of country X appreciates.
2. If country X experiences a higher rate of inflation than country Y, the opposite occurs:
   1. Country X’s exports decrease.
   2. The currency of country X depreciates.

Relative Interest Rates

As mentioned in previous chapters, when interest rates are higher, the incentive to hold cash decreases and the incentive to invest increases.

1. If country X offers relatively higher interest rates than country Y:
   1. Investors from country Y may move their money to country X to earn higher returns.
   2. This increases the demand for country X’s currency, causing it to appreciate.
2. At the same time:
   1. The supply of country Y’s currency increases, causing the currency of country Y to depreciate.

Relative Growth Rates

Imagine two trading partners, country X and country Y.

1. If the economy of country Y grows faster than that of country X:
   1. Incomes in country Y increase, leading to higher demand for goods from country X.
   2. The demand for country X’s currency increases, causing it to appreciate.
2. At the same time:
   1. The supply of country Y’s currency increases, causing it to depreciate.

Central Bank Intervention

1. Central banks sometimes intervene to influence the exchange rate of their currency.
2. Since all central banks hold foreign currency reserves:
   1. If a central bank wants to increase the demand for its currency, it can sell foreign reserves to buy its own currency.
   2. This action appreciates their currency as the demand of their currency increases.