Why Does a Currency Rise or Fall in Value?
The diagram trades domestic currency. Its horizontal axis measures domestic units traded per period; its vertical axis is foreign currency per domestic unit. Demand slopes down and supply up. E1 is their initial intersection, where planned purchases equal sales.
Builds on: How Do We Convert Currencies and Measure Exchange-Rate Changes?
What you will learn
- Trace who buys or sells the named currency before shifting a curve.
- Explain conditional interest-rate and expectation effects
- Draw equilibrium and shifts with explicit units
Essential definitions
- Demand for a currency
- Purchases of that currency in exchange for another currency.
- Supply of a currency
- Sales of that currency in exchange for another currency.
- Capital flow
- A cross-border movement of funds associated with acquiring assets or financial claims.
- Direct investment
- Cross-border investment creating a lasting ownership interest and influence.
- Portfolio investment
- Investment in securities without a direct-investment relationship.
- Remittances
- Money transferred across borders by individuals, often to family members.
Read the currency market
The diagram trades domestic currency. Its horizontal axis measures domestic units traded per period; its vertical axis is foreign currency per domestic unit. Demand slopes down and supply up. E1 is their initial intersection, where planned purchases equal sales.
If demand rises from D1 to D2 against unchanged supply, E2 has a higher quote: domestic appreciation. If supply rises from S1 to S2 against unchanged demand, E2 has a lower quote: depreciation. Read the projections to compare rate and quantity. These are separate experiments, not simultaneous predictions.
Follow trade and transfers
Foreign customers buying domestic exports may buy domestic currency, increasing demand. Residents buying imports may sell it to obtain foreign currency, increasing supply. Higher overseas income can support export demand; higher domestic income can raise import purchases. Higher relative domestic inflation can weaken competitiveness and encourage imports.
Incoming personal transfers, or remittances, can raise demand when foreign funds are converted to domestic currency. Outgoing transfers can raise supply. Actual settlement is more complicated, but the transaction identifies the underlying direction rather than treating all foreign payments alike.
Add investment, returns and expectations
Inward direct investment buys or establishes businesses; inward portfolio investment buys securities such as bonds. Both can create currency demand when funds are converted. Outward investment can increase supply. Higher domestic interest returns relative to abroad may attract investors, but expected depreciation or default risk can outweigh the advantage.
Expected appreciation can encourage purchases now, while expected depreciation encourages sales. These expectations can amplify movements. When several determinants change, identify each curve shift; opposing effects can leave the rate uncertain. State the quote direction and which curve is held fixed before claiming a definite appreciation or depreciation.
Hypothetical market shifts
- Take the vertical axis as EUR per USD. Initially the market clears at 0.80.
- Stronger foreign demand for US exports increases demand for USD, other things equal.
- If the new intersection is 0.84, USD has appreciated because each dollar now buys more euros.
A demand increase for the named domestic currency shifts its demand curve right, with appreciation measured in the specified quote.
Currency demand and appreciation
Stronger export demand, inward investment or incoming remittances can increase demand for domestic currency. Holding supply fixed, the currency appreciates.
How to read this diagram
- Put domestic currency traded per period horizontally and foreign currency per domestic unit vertically. D1 and S1 meet at E1.
- Shift its demand curve right to D2, leaving S1 fixed.
- Mark E1 and E2 and project the higher exchange rate and traded quantity.
From E1 to E2, the rate rises from 0.90 to 1.00; traded quantity rises from 60 to 70 million domestic units.
On a small screen, scroll the graph horizontally to read all labels.
Assumptions and limits: Vertical quote is foreign currency per domestic unit. Other flows and expectations are held fixed.
Currency supply and depreciation
Higher import spending or outward investment can increase supply of domestic currency. With demand unchanged, the price of domestic currency falls.
How to read this diagram
- Put foreign currency per domestic unit vertically and domestic currency traded per period horizontally. Draw D1 and S1 meeting at E1.
- Shift supply right to S2 as residents sell more domestic currency.
- Mark E2 at D1–S2. Compare both equilibria; depreciation is a fall in this quote.
From E1 to E2, the rate falls from 0.90 to 0.80; traded quantity rises from 60 to 70 million domestic units.
On a small screen, scroll the graph horizontally to read all labels.
Assumptions and limits: Foreign currency per domestic unit vertically; a market for the domestic currency, not its reciprocal quote.
Apply and evaluate
- Compare expected returns after risk and expected currency changes, not interest rates in isolation.
- Trade contracts and financial transactions occur on different timescales, so immediate and later effects can differ.
Common misconceptions
- Higher domestic income commonly raises currency supply through imports; it does not automatically raise currency demand.
- Higher interest rates do not guarantee appreciation when risk or expectations change.
Knowledge check
Residents buy more foreign bonds. Which side of the domestic-currency market is affected in the simple model?
What to remember
Trace who buys or sells the named currency before shifting a curve. Trade, asset purchases, transfers and expectations can reinforce or offset each other, so one transaction does not determine the whole market.
Completion records your reflection, not a test score.
Lessons in this section
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