Macroeconomics: foreign exchange market

A currency exchange rate tells us about the value of a currency relative to another currency.

We say that a currency appreciates when its relative value goes up. We say that a currency depreciates when its relative value decreases.

In a market that relates two currencies, if one appreciates, it must be the case that the other currency depreciates.

Demand in the foreign exchange market: it represents the quantity of a currency demanded by agents who are holding other currencies. The agents want to buy goods, services, or financial assets from a country whose currency is demanded.

The demand must be downward slopping. The weaker the currency, the more attractive the goods produced in that country are, and foreign consumers need to hold more of that currency in order to buy the products. Thus, a change in the exchange rate leads to a movement along the demand curve.

Supply in the foreign exchange market: it represents the willingness of people in the country supply to foreigners their domestic currency.

The supplier of the domestic currency are also the demander of a foreign currency. The supply curve is upward slopping. As a currency appreciates, it makes foreign goods relatively cheaper, which increases the demand for foreign money thereby increasing the quantity of domestic money supplied in the foreign exchange market.

Equilibrium exchange rate: it is located where the demand intersects the supply curve.

Note that if in the market for euros in the US the equilibrium exchange rate is 1 euro is worth $1.22 then it must be the case that in the market for dollars in the eurozone, the equilibrium exchange rate is $1 is equal to about 0.82 euros.

A change in one market also causes a change in the other market. For example, if the American demand for euros increases (i.e the demand shifts to the right), then it must be the case that the supply of dollars shifts to the right in the market for dollars in the eurozone.

Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 251-258.

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