In this lesson, you'll learn why money from different countries has different values of exchange. We'll cover the supply and demand for currencies and how changes in supply and demand can affect the exchange rates between currencies.
Introduction to Foreign Currency Exchange
Have you ever been on vacation in a foreign country and wondered about the exchange rate? For example, why is it that a Canadian dollar is just about the same as a U.S. dollar, while a U.S. dollar is worth over 12 Mexican pesos? Where do these conversion rates come from anyway? Well, just like the price of any good, exchange rates are determined on open markets under the control of two forces: demand and supply. Remember the laws of demand and supply?
Law of Demand
The law of demand says that the demand for a good falls as the price rises and goes up as the price falls. We see this happen every year on Black Friday. So, price and demand are inversely related.
Law of Supply
Supply is simply the amount of goods owners or producers offer for sale. The law of supply says that the quantity of a good supplied rises as the market price rises and falls as the price falls. In other words, price and supply are directly related: If price goes up, supply will increase; if price goes down, supply will decrease. The idea here is that when the price of something you own goes up, you're more inclined to sell it. Suppliers work the same way; if the price of a good that they produce goes up, then there is a higher incentive to sell more of that good.
Supply and Demand for Currency
Just like the value of a good is determined by the supply and demand for that good, the value of a nation's currency is determined by the supply and demand for that currency. For example, during the 2012 Summer Olympics in London, tourism to England increased. That could have caused an increase in demand for the British pound and the value of the pound to rise. Generally, exchange rates vary as demand for goods from nations vary. More demand for British goods, for example, would change the demand for the British pound. Just as supply and demand dictate the value of a good, supply and demand will dictate the value of the British pound as well.
Demand for Currency
What would you do if you could buy your school books at a lower price from a supplier in England than in the U.S.? You would probably go online and order the book from the British company and save money. But before you can buy your school books from the British supplier, you'll have to exchange your money for the British pound. Even if they accept U.S. dollars, the seller from England ultimately wants to be paid in pounds. So, eventually the money will get exchanged. The better deal creates higher demand for English currency.
The demand curve for British pounds in terms of the U.S. dollar is a normal downward sloping demand curve. This is because if the value of the British pound went down relative to the U.S. dollar, the quantity of pounds demanded by Americans would increase; when pounds go on sale, more pounds are sold! Pretty much the same idea behind the demand of a good.
For Americans, British goods are less expensive when the pound is cheaper and the dollar is stronger. Assuming there is only trade between the U.S. and England, when the value of the British pound goes down, Americans will switch from American-made goods to British-made goods. But before we can purchase goods made in Britain, we have to exchange dollars for British pounds. Consequently, an increased demand for British goods is simultaneously an increase in the quantity of British pounds demanded. In other words, when the price of British pounds goes down, demand for British pounds goes up.
Supply for Currency
On the flip side, the supply curve for British pounds in terms of the U.S. dollar is a normal upward sloping supply curve. If the value of the U.S. dollar went down, people from England would want to buy more of our goods. Their demand for U.S. dollars would go up, so they would supply or exchange more of their British pounds for U.S. dollars; thus, the supply of British pounds on the international market increases. To summarize, as more American goods are demanded, this causes a simultaneous increase in the supply of British pounds to purchase those goods.
Think of it like this: You have all the U.S. dollars in the world. The only way for someone from England to convert their pounds into dollars is to come to you and trade, so you end up with more British pounds than you had before. Effectively, the decrease in the value of the dollar has created a higher supply of pounds. From the perspective of the British, the supply curve of the British pound is really the demand curve of the U.S. dollar.
Demand and Supply Changes
Understanding how various events cause currencies to experience changes in supply and demand is very important in understanding how exchange rates change. An increase in the U.S. demand for the pound (like the example of cheaper books from England) creates a rightward shift of the demand curve and ultimately causes a rise in the exchange rate, increasing the value of the pound and decreasing the value of the dollar.
This happens because you'd rather exchange your dollars and get pounds in return. Lower demand for dollars means lower value for the dollar; higher demand for pounds means higher value for the pound. Conversely, a fall in demand would shift the demand curve left and lead to a falling pound and rising dollar. This would happen if a non-British book supplier starts offering lower prices.
On the supply side, an increase in the supply of pounds to the U.S. market causes a supply curve shift to the right. A new intersection for supply and demand occurs at a lower exchange rate, and the dollar appreciates against the pound because of the increased supply of pounds. You can now buy more pounds with each dollar you have! A decrease in the supply of pounds shifts the curve leftward, causing the exchange rate to rise and the dollar to depreciate. Your dollars now buy fewer pounds!
In summary, just like how prices are determined for goods at your local grocery store, so are the prices of currencies on exchange rates. The law of supply and demand guides the value and rates for dollars, pounds, yen, pesos and many other currencies.
When individuals purchase goods from other countries or travel outside of their country's borders, they often must first convert their currency into foreign currency. As this happens, exchange rates vary just as demand for goods and services from nations vary. More demand for American goods, for example, would change the demand for the American dollar.
Just like a regular demand curve for a normal good, the demand curve for individual currencies is downward sloping. If the value of a currency declines (it becomes cheaper), the quantity of that currency demanded by foreign consumers would increase, all else constant. The point at where the demand and supply curves intersect determines the market exchange rate.
An increase in the demand for a currency creates a rightward shift of the demand curve, ultimately causing a rise in the exchange rate and increasing the value of the currency demanded. Conversely, a fall in demand would shift the demand curve left and lead to a decline in the currency value.
On the supply side, an increase in the supply of a currency will shift the supply curve to the right, ultimately creating a new intersection for supply and demand and a lower exchange rate for the currency. A decrease in the supply of a currency shifts the curve leftward, causing the exchange rate and the value of the currency to rise.
When this lesson is done, you should be able to:
- Define the law of supply and the law of demand
- Describe the relationship between the demand for currency and the supply for currency
- Determine what may alter currency supply and demand