Exchange Rates – A Matter of Supply and Demand
Nick Potts, Southampton Solent University
Put online November 2009
This text is extracted from Economic and Monetary Union: Exchange rates & the ERM, a set of lecture notes from a module on the European Business Environment.The materials are available via the Heterodox Economics Education wiki or the European Economics wiki. The text is available under a Creative Commons license, some rights reserved.
A country’s exchange rates with other countries will move to ensure that the total demand for its currency equals the total supply of its currency (as the price of apples changes to match the demand and supply of apples). The total demand and supply for a country’s currency is recorded in its balance of payments.
Whenever someone sells a country’s domestic currency (for the UK the Pound) for foreign currency (for the UK, Euros, Dollars etc) they create a demand for foreign currency/a supply of domestic currency. Conversely if someone buys a country’s domestic currency with foreign currency they create a demand for domestic currency/a supply of foreign currency.
If the total demand for domestic currency/supply of foreign currency equals the total supply of domestic currency/demand for foreign currency that country’s balance of payments is in balance. There is no reason for its exchange rates to rise or fall; its exchange rates can stay constant.
If a country’s balance of payments moves into deficit (the supply of domestic currency exceeds the demand for domestic currency) its exchange rates will fall/depreciate (reducing the price of domestic currency/increasing the price of foreign currency) until the overall balance of payments is in balance again.
If a country’s balance of payments moves into surplus (demand for domestic currency exceeds the supply of domestic currency) its exchange rates will rise/appreciate until overall balance in its balance of payments is restored.
As foreign exchange markets are very centralised (for example in London) and competitive exchange rates rapidly adjust to surpluses or deficits in the balance of payments making such imbalances very short lived (with adjustment possible today in seconds as computers automatically buy and sell currencies). But why do people actually buy and sell currencies?