Foreign Exchange Market Notes

6.3 The Foreign Exchange Market

Define the foreign exchange market, demand for currency, and supply of currency.
Explain, using graphs, the relationship between exchange rates and the quantity of currency demanded and supplied.
Explain how exchange rates adjust to restore equilibrium.

The foreign exchange market is where buyers and sellers exchange one country’s currency for another.
This market determines the equilibrium exchange rate in a flexible exchange market.
It also influences the flow of goods, services, and financial capital between countries.

The demand for a currency (e.g., U.S. Dollar) comes from people or businesses in other countries (like Pirate Land) who want to buy goods, services, or invest in financial assets.
Example: If Pirate Land wants to buy iPhones or invest in the U.S. stock market, they will need U.S. Dollars, creating demand for dollars.
The demand for a currency in a foreign exchange market arises from the demand for the country's goods, services, and financial assets.
There is an inverse relationship between the exchange rate and the quantity demanded of a currency.
Elements on the graph:
- X-Axis (Q of dollars): Quantity of U.S. dollars demanded.
- Y-Axis (R/$): Price of dollars in Reales (how many Reales are needed to buy one Dollar).
- The downward-sloping line (D) shows the inverse relationship:
  - When the price of Dollars is high (more Reales needed per Dollar), people in Pirate Land demand fewer Dollars.
  - When the price of Dollars is low (fewer Reales needed per Dollar), people in Pirate Land demand more Dollars.
- As the Dollar becomes cheaper, people demand more. As it becomes expensive, they demand less.
Arrows on the Graph:
- Increase →: If demand for U.S. goods or investments goes up, the demand for Dollars increases, shifting the demand curve to the right.
- Decrease ←: If demand for U.S. goods or investments goes down, the demand for Dollars decreases, shifting the demand curve to the left.

Supply of Dollars comes from people wanting to make payments or investments in other currencies.
The supply of a currency comes from people or businesses selling their own currency to buy foreign currency.
Example: If U.S. citizens want to buy products from Pirate Land or invest there, they need to exchange U.S. Dollars for Reales, supplying Dollars into the foreign exchange market.
The supply of a currency in a foreign exchange market arises from making payments in other currencies
Shows the positive relationship between the exchange rate and the quantity supplied of a currency.
Elements on the graph:
- X-Axis: Quantity of Dollars supplied.
- Y-Axis: Price of Dollars in Reales.
- The supply curve slopes upwards because:
  - When the price of the Dollar is high (more Reales per Dollar), Americans are more willing to supply (sell) Dollars to get those Reales.
  - When the price of the Dollar is low, they are less willing to supply Dollars.
- As the price of Dollars increases, more people are willing to supply them.

Equilibrium happens where demand meets supply.
If the price is above equilibrium → Surplus of Dollars.
If the price is below equilibrium → Shortage of Dollars.
Market forces will naturally adjust prices back to equilibrium.
Disequilibrium exchange rates create surpluses and shortages in the foreign exchange market.
Surplus = Qs - Qd
Shortage = Qd - Qs
Market forces drive exchange rates toward equilibrium.