IB DP Economics - Unit 4 - Changes in Demand and Supply of a Currency-Study Notes - New Syllabus

Changes in Demand and Supply for a Currency

In a floating exchange rate system, the value of a currency is determined by the forces of demand and supply in the foreign exchange market.

Changes in economic conditions, trade flows, investment flows, and market expectations can increase or decrease demand and supply for a currency, causing the exchange rate to change

• If demand for a currency increases relative to supply, the currency tends to appreciate.
• If supply of a currency increases relative to demand, the currency tends to depreciate.

Foreign Demand for Exports

When foreign consumers buy more exports from a country, they need that country’s currency to make payments.

• Demand for the currency increases.
• The currency tends to appreciate.
• Export growth strengthens exchange rate demand.

Higher exports therefore increase demand for the domestic currency.

Domestic Demand for Imports

When domestic consumers buy more imported goods and services, they need foreign currencies to make payments.

• Supply of the domestic currency increases.
• The currency tends to depreciate.
• Import growth increases currency outflows.

Higher imports therefore increase supply of the domestic currency.

Inward Foreign Direct Investment (FDI)

Inward FDI occurs when foreign firms invest in businesses or production facilities within a country.

• Foreign investors need domestic currency.
• Demand for the currency increases.
• The currency may appreciate.

Strong investment inflows therefore strengthen the currency.

Outward Foreign Direct Investment (FDI)

Outward FDI occurs when domestic firms invest abroad.

• Domestic firms need foreign currency.
• Supply of the domestic currency increases.
• The currency may depreciate.

Capital outflows therefore weaken the domestic currency.

Inward Portfolio Investment

Portfolio investment refers to investment in financial assets such as stocks and bonds.

When foreign investors buy domestic financial assets:

• Demand for domestic currency increases.
• The currency may appreciate.
• Higher interest rates often attract portfolio investment.

Financial inflows strengthen currency demand.

Outward Portfolio Investment

When domestic investors purchase foreign financial assets:

• Supply of domestic currency increases.
• Demand for foreign currencies rises.
• The domestic currency may depreciate.

Financial outflows therefore weaken the domestic currency.

Remittances

Remittances are transfers of money by workers living abroad to people in their home country.

• Inward remittances increase demand for the domestic currency.
• Outward remittances increase supply of the domestic currency.
• Large remittance inflows may strengthen exchange rates.

Remittance flows therefore influence currency demand and supply.

Speculation

Speculators buy or sell currencies based on expectations about future exchange rate movements.

• If investors expect appreciation, demand increases.
• If investors expect depreciation, supply increases.
• Speculation may cause rapid exchange rate fluctuations.

Expectations can therefore strongly influence currency values.

Relative Inflation Rates

If a country has higher inflation than its trading partners:

• Exports become less competitive.
• Imports become relatively cheaper.
• Demand for the currency decreases.
• The currency may depreciate.

Lower inflation tends to strengthen a currency.

Relative Interest Rates

Higher interest rates usually attract foreign investment.

• Foreign investors seek higher returns.
• Demand for the currency increases.
• The currency tends to appreciate.

Lower interest rates may cause capital outflows and depreciation.

Relative Growth Rates

Economic growth affects imports, exports, and investment flows.

• Strong growth may attract investment inflows.
• However, growth may also increase imports.
• The effect on exchange rates depends on overall demand and supply changes.

Growth can therefore either strengthen or weaken a currency.

Central Bank Intervention

Central banks may intervene in foreign exchange markets to influence exchange rates.

• Buying domestic currency increases demand and supports appreciation.
• Selling domestic currency increases supply and supports depreciation.
• Central banks may use foreign exchange reserves for intervention.

Governments may intervene to stabilize exchange rates or improve trade competitiveness.

Summary of Factors Affecting Demand and Supply for a Currency: