How to Determine Exchange Rates through Supply and Demand
The demand–supply framework enables you to predict the next period’s exchange rate. When you understand this framework, you’ll be able to predict the direction of the change in the exchange rate — in other words, whether a currency will depreciate or appreciate against another currency. Keep the following in mind when applying the demand–supply model to exchange rates:
An exchange rate implies the relative price of a currency. For example, the euro–dollar exchange rate tells you how many euros to give up to buy one dollar. Therefore, this exchange rate implies the price of a dollar in euros.
If the exchange rate is expressed as the dollar–euro rate, it tells you how many dollars to give up to buy one euro. Therefore, this exchange rate implies the price of a euro in dollars.
Certain forces affect the demand for and supply of dollars, or of any other currency, in foreign exchange markets.
The demand–supply model of exchange rate determination implies that the equilibrium exchange rate changes when the factors that affect the demand and supply conditions change.
This example uses the market for dollars as an example, but you can use any market you want. Whichever market you use, be careful when labeling the x- and y-axes of your model. For example, if you have the quantity of oranges on the x-axis, you have to put the price of oranges on the y-axis. Then the supply and demand curves inside the model refer to oranges.
Also, think about the meaning of the demand for and supply of dollars. Who are these people that want to buy or sell dollars or any other currency? They are international banks, multinational companies, speculators, and so on. Whenever they want to buy dollars, they’ll be along the demand curve. Whenever they want to sell dollars, they’ll be along the supply curve.
Price and quantity of the dollar market
If you want to graph the dollar market, the quantity on the x-axis must be the quantity of dollars in the market. Therefore, the price indicated by the y-axis must be the price of dollars in another currency (in this example, the euro). In other words, the exchange rate has to be defined as the euro–dollar exchange rate.
Consequently, the demand and supply curves indicate the demand for and supply of dollars. The figure shows the initial equilibrium exchange rate as 0.89 per dollar.
Even though this example talks about the demand and supply of dollars, don’t think about the domestic money demand and supply. For now, think about foreign exchange markets where market participants buy or sell currencies.
Factors that affect demand and supply
Ceteris paribus conditions are associated with the demand and supply of dollars. These conditions are related to the macroeconomic fundamentals of two countries represented in the exchange rate.
Because the example exchange rate is the euro–dollar rate, the following variables may change in the U.S. or the Euro-zone, which then have an effect on the euro–dollar exchange rate:
In the demand–supply model, these factors are divided into two areas based on how they affect exchange rates. Inflation rate and growth rate are considered trade-related factors. When you apply the changes in one of these factors to exchange rates, you think about the trade between the U.S. and the Euro-zone.
The interest rate, on the other hand, is a portfolio flow–related factor. It means that when one of the country’s interest rate changes, you think about how this change affects the attractiveness of dollar- and euro-denominated securities to American and European investors.
Government restrictions can be related to both trade flows and portfolio flows, depending on the nature of these restrictions.
Note that the changes in inflation, growth, and interest rates, as well as government restrictions, don’t have to be actual changes that you are observing right now. If market participants have expectations regarding these changes, they will act on them now, producing the same results as if these changes were actually happening.