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Exchange Rates - Supply and Demand

Exchange Rates - Supply and Demand
Published:   12 Dec at 9 AM

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One of the key factors that effects
the foreign exchange rates is the supply and demand for each particular
currency. As the exchange rate increases, the demand for the currencies
decreases. Similarly, if the supply of a country's currency increases,
the value of that currency will decrease in relation to other currencies
and more money is needed in order to purchase foreign currencies. The
reason for this is that if the demand increases but the supply stays
constant, the price will obviously goes up because more the supply-demand
ratio drives up the price. In contrast, if the supply goes up but the
demand stays the same (or goes down) then the value of that currency
will fall.

The supply of foreign exchange shifts
depending on demand and not on the exchange rate. If the supply aspect
of transaction is plotted on a graph it will be vertical since the supply
of foreign currency deposits available at any time is fixed.

The supply and demand of foreign
exchange depends on lots of factors. They are:

  • Economic Factors have
    a direct impact on the foreign exchange market, for example economic
    policies formulated by central Banks and government agencies, economic
    reports, conditions and other economic indicators all of which can cause
    fluctuations in currency prices.

  • Similar to the first point,
    political conditions within and around any particular country who's
    currency you are contemplating purchasing, also affect the currency
    market. Regional, central and international politics cast a profound
    effect on the currency and can often have knock-on effects on other
    currencies and the foreign exchange market as a whole.

  • The Market Psychology
    and the feelings of the traders and buyers who will be making the majority
    of the purchasing will affect the currency market in a range of different
    ways. All these factors can have a direct impact on the currency market
    and in turn the supply and demand of foreign exchange fluctuations.

  • The final point we
    will discuss is the
    equilibrium in the Foreign Exchange Market as
    this can also have a big impact on the value of currencies. Regardless
    of what the exchange rate may be at any given time, the aim of the world
    economies as a whole is to maintain this equilibrium. The foreign exchange
    market is generally perceived to be in a state of equilibrium when the
    deposits of all the currencies provide equal rate of return that was
    expected. The Basic Equilibrium condition depends on interest rate parity.
    The interest rate parity condition is achieved when the anticipated
    returns on deposits of any two currencies are same when evaluated in
    the same currency. This essentially means that the assets are valued
    as equals. The potential foreign currency holders perceive all of them
    as equally desirable assets.

« Exchange Rates - What are they and how are they calculated?

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