1.

2 The market for foreign currency

Figure 1.1. Supply and demand in the
market for foreign currency What is the motivation behind the demand and supply
curves in Figure 1.1.(b)?
What kind of agent supply & demand foreign currency?

3 categories
1) Exporters/importers
Exporters supply goods to foreign buyers (foreign currency
/sterling) ⟹ supply of foreign exchange = dollars (if exports
sold in USA)
Importers buy goods from foreign suppliers ⟹ demand of
foreign exchange = dollars
 1.2 The market for foreign currency
Figure 1.1. Supply and demand in the
market for foreign currency
What is the motivation behind the demand and supply
curves in Figure 1.1.(b)?
3 categories
2) Foreign investors : buy sterling to purchase UK assets
British investors: sell pounds for dollars
3) Speculators: profit (buying or selling foreign exchange)
How will these three kinds of agent be influenced by the
exchange rate?
 1.2 The market for foreign currency
Figure 1.1. Supply and demand in the How will these three kinds of agent be influenced by the
market for foreign currency exchange rate?

importers and exporters

H1: If price of $ is low (pound more expensive):
𝐷𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 $ > 𝑆𝑢𝑝𝑝𝑙𝑦 𝑜𝑓 $
- Sterling price of UK products ⟹ prices of UK products
appear more expensive to Americans after conversion:
- ↘ exports from Britain
- ↗ imports from USA (dollar-priced imports)
⟹↗ 𝐷 𝑓𝑜𝑟 $+ ↘ 𝑆𝑢𝑝𝑝𝑙𝑦 𝑜𝑓 $
 1.2 The market for foreign currency
Figure 1.1. Supply and demand in the
market for foreign currency
How will these three kinds of agent be influenced by the
exchange rate?
H1: If price of $ is low (pound more expensive):
long-term investors
- US investors: Need more $ to buy asset in Britain
- UK investors: find US assets cheap to buy with sterling
 1.2 The market for foreign currency
Figure 1.1. Supply and demand in the
market for foreign currency
How will these three kinds of agent be influenced by the
exchange rate?
H1: If price of $ is low (pound more expensive):
Speculators
Volatilty of ER: high value for a currency: this currency will
decrease in the future (⟹ its selling = loss in capital)
𝐷𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 $ > 𝑆𝑢𝑝𝑝𝑙𝑦 𝑜𝑓 $
Conversely: if dollar is expensive
𝐷𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 $ < 𝑆𝑢𝑝𝑝𝑙𝑦 𝑜𝑓 $
 1.2 The market for foreign currency
Figure 1.1. Supply and demand in the Equilibrium: $1 = £0.50
market for foreign currency

Below: $1 = £0.40:
D > S: Excess demand
Above : $1 = £0.70:

S > D: Excess supply

Excess demand curve (left side of this slide):

downward
 1.2 The market for foreign currency
Figure 1.1. Supply and demand in the Any demand and supply diagram can be redrawn in terms of
market for foreign currency excess demand alone

- market for a consumer good

- currency markets

The suppliers and demanders will often be the very same

individuals or institutions.
 1.2 The market for foreign currency
Figure 1.1. Supply and demand in the Exporters/importers
market for foreign currency

Investors

$1 = £0.70

$1 = £0.40
 1.2 The market for foreign currency
Figure 1.1. Supply and demand in the
market for foreign currency

Speculators

- Demanding dollars
- Supplying dollars
 1.2 The market for foreign currency
Figure 1.1. Supply and demand in the
market for foreign currency

Think in terms of the net demand for a currency

Able to use the S/D curves again

1.2.1. Floating rates
Figure 1.2. Shift in the excess demand for $1 = £0.50
foreign currency

𝑋 to 𝑋

𝑋
Orders to sell £ > orders to buy £
Need to change the price
ES of £
ED for $
1.2.1. Floating rates
Figure 1.2. Shift in the excess demand for excess of demand for the dollar (𝑋 )
foreign currency

ES of £
ED for $

$1 = £0.50 ⟶ $1 = £0.70
1.2.1. Floating rates
Figure 1.2. Shift in the excess demand for 𝑋 to 𝑋
foreign currency Excess supply of dollars for an amount of 𝑋 (<0)

(point A)

ER: market forces

Definition:
Completely flexible (purely or freely) floating exchange rate

Convention 1.5.
Unless otherwise specified, the analysis assumes a freely
floating exchange rate.