Demand in the FX Market
Same Laws Apply to Currency Markets as to Anything Else People Value
Why the current exchange rate, as well as the expected exchange rates and interest rates, determine the demand for a currency in the foreign exchange market.
How much of a currency a trader plans to buy in a given period and at a certain exchange rate determines the demand for that currency. Before the trader makes his or her move, there are three main factors that must be taken into consideration:
- the current exchange rate;
- the level of interest rates; and,
- the expected future exchange rate.
The Law of Demand for a Currency
No one buys any currency because they like to collect pretty bills. People buy currency when they want to invest or buy goods and services in foreign markets, which is why the demand for a currency is also referred to as a derived demand.
Everything else being equal, the pricier a currency, the less quantity of it is demanded. For example, if the price of the U.S. dollar relative to Japanese yen increases from ¥100/$ to ¥120/$, provided nothing else changes, the quantity of the U.S. dollar demanded is likely to decrease.
There are two reasons why the exchange rate has such impact on the quantity demanded of a currency:
- the effect on exports; and
- the effect on expected profits.
The more a country exports, the more its exports are valued, depending, of course, on how the foreign exchange market values the country’s currency. In essence, the lower the exchange rate of a country’s currency, its goods and services will also cost less in international markets. So, if the country’s exports are cheaper to foreigners, the demand for those goods and services is likely to increase and the quantity demanded of the country’s currency is also likely to increase. This relationship is called the exports effect of the derived demand for a currency.
Furthermore, if foreign exchange traders expect to haul in profits by holding a currency, they are likely to want to buy more of that currency in the foreign exchange market, thus increasing the demand for it. Again, however, the expected profits will depend on the foreign exchange rate. Everything else being equal, the lower the exchange rate, the larger the expected profits, and the greater the demand for that currency. This relationship is called the expected profit effect of the derived demand for a currency.
What Shifts the Demand Curve of a Currency?
While the exchange rate impacts the quantity demanded of a currency, changes in interest rates and expected future exchange rates impact the demand itself and shift the demand curve of a currency.
Investors and companies buy financial assets such as currencies to earn profit. If interest rates on financial assets in Country A are higher than in Country B, foreigners are likely to invest more in Country A than in Country B.
Now, the level of interest rates in Country A alone are not all that matters. What matters more is the difference between interest rates in Country A and Country B, the gap which is referred to as the interest rate differential. So, if interest rates in Country A increase, while interest rates in Country B remain the same, the Country A’s interest rate differential is going to increase too, making its financial assets all that much more attractive to foreign investors.
As far as the expected future exchange rate is concerned, it also has the power to shift the demand curve for a currency. The correlation between the two variables is simple: the higher the expected future exchange rate of a currency, the higher the demand for the currency.
Why is it important to understand what increases the quantity demanded and/or shifts the demand curve for a currency? Considering that many individuals and governments often invest in foreign countries’ assets, goods and services, understanding the laws of demand for a currency makes a lot of sense to those wanting to engage in profitable transactions.
To learn more about the laws of supply in the FX market, read the next article in this two-part series.
Source: Economics, Seventh Edition, by Michael Parkin, Pearson Education, 2005.
