October 13, 2010Economic Theoryby EconomyWatch

Demand and Supply of Foreign Exchange

Demand and Supply of Foreign Exchange influences the determination of exchange rates and vice versa. The demand for foreign exchange is inversely proportional to the rise of exchange rate. As the exchange rate goes up the demand for foreign exchange declines. The quantity of foreign exchange demanded falls. The supply of foreign exchange shifts depending on demand and not on the exchange rate. If the supply aspect of transaction is plotted on a graph it will be vertical since the supply of foreign currency deposits available at any time is fixed.

If the supply of a country’s currency increases the value of the currency decreases in relation to other currencies and more money is required to buy the foreign exchanges.

Foreign Exchange Market

The transaction of a currency takes place in the foreign exchange market. The supply of a currency depends on the ups and downs of the market. In the market large financial institutions and banks trade with money.

Factors Affecting Demand and Supply of Foreign Exchange

The supply and demand of foreign exchange depends on lots of factors. They are:

  • Economic Factors that include economic policies formulated by central Banks and government agencies, economic reports, conditions and other economic indicators.
  • Political conditions within and around the country also affect the currency market. Regional, central and international politics cast a profound effect on the currency market.
  • The Market Psychology and the perception of the traders and buyers also affect the currency market in various ways.All these factors affect the currency market and in turn the supply and demand of foreign exchange falters.

    Equilibrium in the Foreign Exchange Market

    Whatever the exchange rate may be the aim of world economy is to maintain equilibrium. The foreign exchange market is considered to be in equilibrium when the deposits of all the currencies provide equal rate of return that was expected. The Basic Equilibrium condition depends on interest rate parity. The interest rate parity condition is achieved when the anticipated returns on deposits of any two currencies are same when evaluated in the same currency. This essentially means that the assets are valued as equals. The potential foreign currency holders perceive all of them as equally desirable assets.

  • BOP Theory of Exchange Rate
  • Theory of Exchange Rate Determination
  • Purchasing Power Parity Theory of Exchange Rate
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