🛍 Demand for the hadri
People who need to buy hadris: foreign buyers of Hadria's exports, foreign tourists visiting Hadria, and foreign savers and firms who want to invest in Hadria.
Foreign Exchange Rates » How Exchange Rates Are Determined
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 6.3.3
- What a floating exchange rate is, and what appreciation and depreciation mean
- Who demands a currency and who supplies it
- How to find the equilibrium exchange rate on a diagram
- How exports, imports, interest rates and speculation move the rate
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Unlock This CourseA currency has a price, and the market sets it
You already know that an exchange rate is the price of one currency in terms of another. Like any price, it is set where demand meets supply. The place where this happens is the foreign exchange market.
Key terms:
- Floating exchange rate: an exchange rate that is determined by the demand for and supply of a currency in the foreign exchange market, without the government fixing it.
- Appreciation: a rise in the value of a currency compared with another currency.
- Depreciation: a fall in the value of a currency compared with another currency.
Use a made-up country, Hadria, whose currency is the hadri. Suppose 1 hadri costs $0.50. If the price of 1 hadri rises to $0.60, the hadri has appreciated against the dollar. If it falls to $0.40, the hadri has depreciated against the dollar.
Who demands a currency and who supplies it
💲 Supply of the hadri
People who sell hadris to get foreign currency: Hadrian buyers of imports, Hadrian tourists going abroad, and Hadrian savers and firms who want to invest abroad.
Remember the reasons for trading currencies from the previous lesson. Every reason for buying hadris adds to demand for them. Every reason for selling hadris adds to their supply.
The demand curve for a currency slopes downwards. The cheaper the hadri is in dollars, the cheaper Hadrian goods are for foreign buyers, so more hadris are demanded. The supply curve slopes upwards. The more dollars each hadri buys, the more attractive foreign goods become to Hadrians, so more hadris are supplied.
The equilibrium exchange rate
Here is a made-up schedule for the hadri. Quantities are in millions of hadris per week.
| Price of 1 hadri ($) | Demand | Supply |
|---|---|---|
| 0.30 | 80 | 20 |
| 0.40 | 65 | 35 |
| 0.50 | 50 | 50 |
| 0.60 | 35 | 65 |
| 0.70 | 20 | 80 |
Demand equals supply at $0.50, where 50 million hadris are traded each week. This is the equilibrium exchange rate. At $0.60 there would be a surplus of hadris, so the price would fall. At $0.40 there would be a shortage, so the price would rise.
How to draw it
1. Label the vertical axis Price of the hadri ($). The price of the currency always goes on the vertical axis. 2. Label the horizontal axis Quantity of hadris. 3. Draw a downward sloping demand curve and label it D. 4. Draw an upward sloping supply curve and label it S. 5. Mark the point where they cross. Go across to the vertical axis and label the equilibrium rate P1. Go down and label the equilibrium quantity Q1.
Why the exchange rate changes
The exchange rate moves when demand or supply shifts. Each cause below is shown on the diagram as a shift of one curve.
Changes in demand for exports and imports
Suppose foreign buyers want more of Hadria's coffee. They need hadris to pay for it, so demand for the hadri increases and D shifts right to D1. The new equilibrium rate P2 is higher than P1, so the hadri appreciates.
Now suppose Hadrians want to buy more imported cars. They must sell hadris to get foreign currency, so the supply of hadris increases and S shifts right to S1. The new equilibrium rate P2 is lower than P1, so the hadri depreciates.
Changes in the interest rate
If Hadria's interest rate rises compared with other countries, savings in Hadrian banks earn more. Foreign savers buy hadris to deposit them there, so demand for the hadri increases (D shifts right) and the hadri appreciates. If Hadria's interest rate falls, saving there is less attractive. Demand for the hadri falls (D shifts left) and the hadri depreciates.
Speculation
Speculators buy and sell currencies hoping to make a profit. If they expect the hadri to rise in value, they buy it now. Demand increases, D shifts right and the hadri appreciates. If they expect it to fall, they sell it now. Supply increases, S shifts right and the hadri depreciates. Speculation can even make the expected change happen.
📈 Appreciation
Demand shifts right or supply shifts left. The price of the currency rises.
📉 Depreciation
Demand shifts left or supply shifts right. The price of the currency falls.
💡 Check
Always ask: is it buyers of the currency or sellers of the currency who have changed?
Worked example
Foreign demand for Hadria's coffee rises. At every price, demand for hadris is 30 million higher. The new demand figures are 110, 95, 80, 65 and 50 at prices from $0.30 to $0.70. Supply is unchanged. Demand now equals supply at $0.60, where both are 65 million. The rate has risen from $0.50 to $0.60, an appreciation of 20% ($0.10 / $0.50 x 100).
Common mistakes
Mixing up the two curves: people who want to buy the currency are demand, people who want to sell it are supply. Putting quantity on the vertical axis: the price of the currency goes on the vertical axis. Saying a shift is a movement along a curve. Also remember that if one currency appreciates, the other depreciates against it.
Exam-style question
Soravia is a country whose currency is the sora. Its exports of fruit have fallen, and the central bank has cut the interest rate.
(a) Define 'depreciation'. [2 marks]
(b) Explain how a fall in demand for Soravia's exports could cause the sora to depreciate. [4 marks]
(c) Analyse how a cut in the interest rate could affect the exchange rate of the sora. [6 marks]
Model answer
(a) Depreciation is a fall (1) in the value of a currency compared with another currency (1).
(b) Foreign buyers need soras to pay for Soravian exports (1). If they buy fewer exports, they buy fewer soras, so demand for the sora falls (1) and the demand curve shifts left (1). This lowers the equilibrium price of the sora, so it depreciates (1).
(c) A lower interest rate makes saving in Soravian banks less attractive compared with other countries (1). Foreign savers buy fewer soras to deposit there (1), so demand for the sora falls (1). Some Soravian savers may sell soras to put their money abroad, so supply increases (1). The demand curve shifts left, or the supply curve shifts right (1), so the equilibrium exchange rate falls and the sora depreciates (1).
Exam tip
For part (c), name which curve shifts and which way, then say what happens to the price of the currency. Analysis questions need a chain of steps, not just the answer.