demand and supply of foreign currency

Demand and Supply of Foreign Currency

By admin, April 4, 2016

The fundamental concept in Fundamental Analysis is Demand and Supply of foreign currency and how it can affect an exchange rate.

Currency exchange rate is a key connecting link for a national economy and other countries. Each country or currency zone uses it’s own monetary unit which is called a currency. Monetary units of other countries are a foreign currency for a national economy. The foreign currency is measured in national currency and as a result arises an equilibrium exchange rate of a foreign currency in comparison to a national currency. If residents (companies, people, governments etc.) are performing economical transactions within their country, they are using the national currency and consequently make demand only for the national currency. For the purpose of research of an exchange rate we need to look to the economical transactions from the International point of view, when the transactions are done by institutional units based in different countries which use different national currencies. Because of that, for the purpose of implementation of International payments, the national currencies of the countries the transactions are done with. As an outcome, the residents of one country are creating a demand for a currency of another country i.e. for a foreign currency. The demand is being created because the residents need to pay for the import of the foreign merchandise, purchase of foreign stocks, purchase of a property abroad or they are just trying to get a speculative income because of currency exchange rate volatility.

Let’s assume, that the volume of aggregate demand of the residents, price level in the country and abroad are constant and there are no international movements of capital. Thereby the demand for foreign currency is indicated only by the import price. If the price of the foreign currency is high and we need to give high amount of the national currency to buy a unit of the foreign currency, then the demand for the foreign currency, as well as for any other merchandise will be low. If the foreign currency depreciates, then we need to pay less amount of national currency to buy a unit of the foreign currency and in that case the demand towards the foreign currency is increasing. In other words, when the exchange rate of a foreign currency appreciates, then the demand descends and when the exchange rate of a foreign currency depreciates, the demand increases.

The supply of foreign currency comes from abroad, from the countries, where that currency is national. None residents are creating supply of their national currency for residents paying for Import of merchandise from residents or paying for stocks or paying for a property or trying to get a speculative income etc.. If we assume, that the volume of aggregate demand of the residents, price level in the country and abroad are constant and there are no international movements of capital, then the only foreign currency supply channel will be the Export. If the foreign currency is expensive i.e. we can buy a high amount of national currency, then the supply of the foreign currency, as well as for any other merchandise will be high. If the foreign currency will depreciate, then the none residents will be able to buy less of the national currency, consequently the supply of foreign currency decreases.

We can look at the correlation of demand and supply of foreign currency from the point of view of an exchange rate. If the exchange rate of the national currency appreciates (less national currency needs to be paid for a unit of a foreign currency), then the demand towards import increases, consequently the demand towards the foreign currency increases too (to pay for the import). Simultaneously, the supply of the currency of none residents i.e. their interest in buying the merchandise of the national export decreases, because for the unit of their currency (foreign currency) they can get less amount of national currency. And the vice versa.

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