The rates at which most currencies exchange for one another are determined by demand and supply. How does the model of demand and supply operate in the foreign exchange market?
The demand curve for dollars relates the number of dollars buyers want to buy in any period to the exchange rate. An increase in the exchange rate means it takes more foreign urrency to buy a dollar. A higher exchange rate, in turn, makes U.S. goods and services more expensive for foreign buyers and reduces the quantity they will demand. That is likely to reduce the quantity of dollars they demand. Foreigners thus will demand fewer dollars as the price of the dollar—the exchange rate—rises. Consequently, the demand curve for dollars is downward sloping, as in Figure 25.3.
The equilibrium exchange rate is the rate at which the quantity of dollars demanded equals the quantity supplied. Here, equilibrium occurs at exchange rate E, at which Q dollars are exchanged per period.
The supply curve for dollars emerges from a similar process. When people and firms in the United States purchase goods, services, or assets in foreign countries, they must purchase the currency of those countries first. They supply dollars in exchange for foreign currency. The supply of dollars on the foreign exchange market thus reflects the degree to which people in the United States are buying foreign money at various exchange rates. A higher exchange rate means that a dollar trades for more foreign currency. In effect, the higher rate makes foreign goods and services cheaper to U.S. buyers, so
U.S. consumers will purchase more foreign goods and services. People will thus supply more dollars at a higher exchange rate; we expect the supply curve for dollars to be upward sloping, as suggested in Figure 25.3.
In addition to private individuals and firms that participate in the foreign exchange market, most governments participate as well. A government might seek to lower its exchange rate by selling its currency; it might seek to raise the rate by buying its currency. Although governments often participate in foreign exchange markets, they generally represent a very small share of these markets. The most important traders are private buyers and sellers of currencies.
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