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Understanding Supply and Demand Dynamics in International Currency Markets

This comprehensive guide explores how supply and demand metrics influence foreign currency exchange rates. By examining economic variables such as interest rates, inflation rates, and income growth, it reveals how changes in these fundamentals affect market behavior. Notably, this guide includes practical examples illustrating the impact of interest rate differentials and inflation disparities on currency valuation. It also discusses the role of international trade, tourism, and central banks, providing insight for both investors and scholars interested in foreign exchange economics.

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Understanding Supply and Demand Dynamics in International Currency Markets

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  1. FX DETERMINATION

  2. Supply and Demand determine St St Supply of FC • Q: What moves Supply & Demand? - International Investing: Foreign Investors investing in the US US Investors investing abroad - International Trade: Exports/Imports - International Tourism - Central Banks. (DC/FC) StE Demand of FC Quantity of FC

  3. Economic Variables (“Fundamentals”) behind Supply & Demand: - interest rates (iUSD - iFC) - inflation rates (IUSD - IFC) - income growth rates (yUSD - yFC) - others: tariffs, quotas, other trade barriers, expectations, taxes, etc. Changes in the fundamentals will affect St. Example 1: Changes in the interest rate differential The U.S. Fed increases interest rates (iUSD ↑) => (iUSD-iEUR)↑ Two effects: - European residents buy more U.S. T-bills (Supply of EUR ↑) - U.S. residents buy less European T-bills (Demand for EUR ↓) => both Supply and Demand curves shift.

  4. Example 1 (continuation): Effect on St: (iUSD-iEUR)↑ => St ? St (USD/EUR) S0 S1 - European residents buy more U.S. T-bills (Supply ↑) A S0= 1.50 B D0 S1= 1.47 D1 Quantity of EUR - U.S. residents buy less European T-bills (Demand ↓) • St moves from A to B => The EUR becomes less expensive in terms of USD. => We say: “the EUR depreciates against the USD”. ¶

  5. Intuition check: The U.S. Fed decreases interest rates (iUSD↓) => (iUSD-iEUR)↓ - European residents buy less U.S. T-bills (Supply of EUR ↓) - U.S. residents buy more European T-bills (Demand for EUR ↑) • St moves from A to B => The EUR becomes more expensive in terms of USD. => We say: “the EUR appreciates against the USD”.¶ St S1 (USD/EUR) B S0 S0= 1.50 S1= 1.45 D1 A D0 Quantity of EUR

  6. Example 2: Changes in the inflation rate differential U.S. inflation increases (IUSD) => (IUSD- IEUR)↑ Foreigners want to buy less U.S. goods (Supply ↓) Americans want to buy more European goods (Demand ↑) • St moves from A to B => The EUR becomes more expensive in terms of USD. ¶ S1 St (USD/EUR) B S0 S0= 1.50 A S1= 1.45 D1 D0 Quantity of EUR

  7. Intuition check: U.S. inflation decreases relative to European inflation (IUSD-IEUR) ↓ => St ? St S0 (USD/EUR) S1 - European residents buy more U.S. goods (Supply of EUR ↑) - U.S. residents buy less European goods (Demand for EUR ↓) A S0= 1.50 B D0 S1= 1.47 D1 Quantity of EUR • St moves from A to B • => The EUR becomes cheaper in terms of USD.

  8. Example 3: Changes in other factors: Tariffs U.S. government imposes tariffs on Korean steel. Assume no trade wars. St S0 (USD/EUR) - U.S. residents buy less Korean goods (Demand for WRN ↓) - No movement on U.S. exports to Korea (Supply unchanged) A S0= 1.50 B D0 S1= 1.48 D1 Quantity of WRN • St moves from A to B • => The WRN becomes cheaper in terms of USD.

  9. Example 4: Changes in other factors: Uncertainty Uncertainty (political, social, war, terrorism threats, etc) increase. Suppose Switzerland is considered a safe haven. - Foreign residents bring less CHF to the U.S. (Supply of CHF ↓) - U.S. residents buy more CHF (Demand for CHF ↑) • St moves from A to B => The CHF becomes more expensive in terms of USD. ¶ S1 St (USD/CHD) B S0 S1= 1.04 A S0= 1.00 D1 D0 Quantity of CHF

  10. Example 5: Changes in export prices The price of oil decreases significantly. - Canadian oil exports are worth less USD. (Supply of USD ↓) - There may be a secondary effect –Canadian may be able to buy less imports. (Demand for USD may go down) • St moves from A to B => The USD becomes more expensive in terms of CAD. ¶ S1 St (CAD/USD) S0 B S1= 1.01 A S0= 1.00 D0 Quantity of USD

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