The likely effects of such an article are illustrated in the interactive graph below (Figure 2). For example, imagine that a leading business newspaper, like the Wall Street Journal or the Financial Times, runs an article predicting that the Mexican peso will appreciate in value. One reason to supply a currency-that is, sell it on the foreign exchange market-is the expectation that the value of the currency is about to decline. One reason to demand a currency on the foreign exchange market is the belief that the value of the currency is about to increase. What factors would cause the demand or supply to shift, thus leading to a change in the equilibrium exchange rate? Read on to discover the answer to this question. In the actual foreign exchange market, almost all of the trading for Mexican pesos is done for U.S. Note that the two exchange rates are inverses: 10 pesos per dollar is the same as 10 cents per peso (or $0.10 per peso). currency for each Mexican peso and a total volume of 85 billion pesos. The demand curve (D) for Mexican pesos intersects with the supply curve (S) of Mexican pesos at the equilibrium point (E), which is an exchange rate of 10 cents in U.S. The horizontal axis shows the quantity of Mexican pesos traded in the foreign exchange market. The vertical axis shows the exchange rate for Mexican pesos, which is measured in U.S. In both graphs, the equilibrium exchange rate occurs at point E, at the intersection of the demand curve (D) and the supply curve (S).įigure 1(b) presents the same demand and supply information from the perspective of the Mexican peso. (b) The quantity measured on the horizontal axis is in Mexican pesos, while the price on the vertical axis is the price of pesos measured in U.S. dollars, and the exchange rate on the vertical axis is the price of U.S. (a) The quantity measured on the horizontal axis is in U.S. dollars at the equilibrium point (E), which is an exchange rate of 10 pesos per dollar and a total volume of $8.5 billion.įigure 1. dollars intersects with the supply curve (S) of U.S. dollars being traded in the foreign exchange market each day. The horizontal axis shows the quantity of U.S. dollars, which in this case is measured in pesos. The vertical axis shows the exchange rate for U.S. In other words, the peso gains value.įigure 1(a) offers an example for the exchange rate between the U.S. dollar falls relative to the Mexican peso. Thus, the demand for Mexican pesos decreases and the U.S. goes into a recession, then GDP falls and they would import less from Mexico. If GDP grows, it will import more. Everything else held constant, these fluctuations also cause a shift in foreign exchange markets. For example, if the GDP falls in one nation, that nation is likely to import less. A variety of factors can influence these exchange rates, including the amounts of imports and exports, GDP, market expectations, and inflation. Similarly, wealthy individuals or businesses make investments in foreign countries for which they need foreign currency also.Įxchange rates are the prices of foreign currencies, which are determined in their respective foreign currency markets. For example, households buy imported goods for which they need foreign currency to pay for them. The foreign exchange market involves firms, households, and investors who purchase foreign goods, services and assets (or who sell goods, services and assets to foreigners). As a result, they demand (or supply) foreign currencies in order to complete their transactions. Define arbitrage and the importance of purchasing power parityĭemand and Supply Shifts in Foreign Exchange Markets.Explain the factors that cause the demand and supply of foreign currencies to shift.
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