Supply in the FX Market
Investors Supply a Currency when They Want to Buy Foreign Assets
As was the case with the demand for a currency, the current exchange rate, expected exchange rate and interest rates also determine its supply in the FX market.
When a trader plans to sell a currency in a given period and at a certain exchange rate, he or she is supplying the currency in the foreign exchange market. Following the same line of reasoning as with the demand for a currency, the quantity of a currency supplied is determined by three dominant factors:
- the exchange rate;
- interest rates; and,
- the expected exchange rate some time in the future.
The Law of Supply for a Currency
When investors from Country A want to buy assets, goods or services made in Country B, they must first buy the currency used in Country B. To pay for Country B’s currency, investors from Country A use their own currency. This is how any currency is supplied in the foreign exchange market—as a means of payment for a foreign currency.
Everything else being equal, the higher the current exchange rate of a currency, the more traders are going to be inclined to sell that currency. Why? The same market forces apply to the supply of a currency in the foreign exchange market as they did to its demand: imports effect and expected profit effect.
When the exchange rate of Country A’s currency increases, the aggregate value of the country’s exports also increases. And if residents of Country B wish to buy (import) assets, goods and services produced in Country A, they will have to sell (supply) more of Country B’s currency in order to buy Country A’s currency and pay for Country A’s exports.
Similarly, if traders from Country B expect large profits from Country A’s currency, they will demand more of that currency and supply more of Country B’s currency to the FX market to pay for Country A’s currency. Everything else being equal, the higher the exchange rate in Country A, the higher the expected profits from holding Country A’s currency, and the higher the quantity supplied of Country B’s currency.
The key expression here is “everything else being equal.” Of course, when the exchange rate in Country A increases, it is true that the country’s exports become more valuable. However, it is also true that those same exports become more expensive to foreigners, too, which is likely to decrease the demand for assets, goods and services produced in Country A and the need for the supply of Country B’s currency.
Note two things! Laws of demand for a currency have already been explained in the previous article. Also, as was true with respect to the demand for a currency, the exchange rate only impacts the move along the supply curve, but it does not shift it.
What Shifts the Supply Curve of a Currency?
The supply curve for a currency will shift when interest rates change, as well as when the expected future exchange rate changes. The term interest rate differential has already been introduced in the article Demand in the FX Market. Note that as the interest rate differential increases, the demand for foreign assets decreases, as does the supply of a currency in the FX market. Furthermore, the higher the expected future exchange rate, the supply of a currency is likely to decrease.
FX Market Equilibrium
What happens when there is neither a currency shortage nor a surplus? At least in theory, the quantity supplied of a currency equals the demand for that currency. This also means that the exchange rate for that currency has reached market equilibrium.
Forces of supply and demand are constantly pulling the FX market toward its equilibrium. This happens because foreign exchange dealers and traders are always looking for the best price they can get. If they are buyers, they want the lowest price possible. If they are sellers, they want the highest price possible.
Dealers and traders then transfer their price information into the worldwide computer network, while their inputs adjust bids and ask for currencies literally every second to keep the supply and demand in balance and the FX market in its equilibrium.
End of two-part series.
Source: Economics, Seventh Edition, by Michael Parkin, Pearson Education, 2005.
