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Figure 8.1 Exchange Rate Determinants
What causes people to demand a foreign currency? The main motivators are people's desires for foreign goods and services and for opportunities to make money in foreign markets. Thus, the demand for foreign currencies comes from the following:
- International trade in goods and services. Suppose Ms. Shepart wishes to buy a French perfume in Topeka, Kansas. She goes to the local drugstore and exchanges dollars for the French perfume, leading her drugstore to place a new order with the French distributor. Thus, Ms. Shepart's demand for a French perfume leads to demand for francs.
- International trade in financial instruments like stocks and bonds. Ms. Shepart reads in The Wall Street Journal that the British government is selling a portion of the British telephone company to the public, so she calls up her stockbroker and asks him to buy 1,000 shares of the British Telephone Company. Ms. Shepart's demand for British stock leads to demand for pounds.
- Purchase of physical assets like real estate, factories, and machinery overseas. Ms. Shepart visits Greece on her summer vacation and likes the climate, so she decides to buy a villa in Rhodes. Ms. Shepart's desire for Greece's sunny beaches leads to demand for drachmas.
In sum, people's demand for foreign goods, stocks and bonds, or real estate creates a demand for foreign currencies. Similarly, people's desire to sell their products and services creates a supply of foreign currency.
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