The demand for and supply of a currency

International Trade & Globalisation – Foreign Exchange Rates

1. What is a Currency?

A currency is the money that a country uses for buying and selling. Think of it as a ticket that lets you trade goods and services in that country.

2. Demand for a Currency

Demand for a currency rises when:

• People want to buy foreign goods (e.g., buying a Nintendo Switch from Japan).
• Investors want to invest abroad (e.g., buying US bonds).
• Businesses need to pay overseas suppliers (e.g., a UK company buying steel from Germany).

Mathematically, we write the demand curve as $D = f(P, Y, \dots)$ where P is the price of foreign goods and Y is income.

3. Supply of a Currency

Supply of a currency rises when:

• Domestic firms sell exports and receive foreign currency.
• Investors sell foreign assets and need domestic currency.
• Central banks intervene by selling or buying foreign reserves.

Supply curve: $S = g(P, \dots)$.

4. Market Equilibrium

The exchange rate $E$ is where demand equals supply:

$D(E) = S(E)$

At this point, the amount of currency people want to buy equals the amount that sellers are willing to sell.

5. Graphical Representation

The downward‑sloping demand curve shows that as the exchange rate falls (currency becomes cheaper), more of it is demanded. The upward‑sloping supply curve shows that as the rate rises, more currency is supplied.

6. Factors that Shift Demand & Supply

1. Trade Balance – A trade surplus increases supply of foreign currency.
2. Interest Rates – Higher domestic rates attract foreign investment, increasing demand for domestic currency.
3. Political Stability – Stable politics boost confidence, shifting demand right.
4. Central Bank Policy – Buying foreign reserves shifts supply left.

7. Example: USD/EUR Exchange Rate

Suppose the US exports a lot of tech gadgets to Europe. European companies need USD to pay US suppliers, so demand for USD rises. If the US also has a trade surplus, it receives more euros, increasing supply of USD. The equilibrium exchange rate is where these forces balance.

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