Question

Briefly how exchange rate are determined by supply of demand.

Answer 1

The demand – supply system helps you to forecast the exchange rate for the next cycle. When you understand this concept, you can forecast the course of the exchange rate change that is, whether a currency will depreciate or increase against another currency, or not. When applying the demand – supply model to exchange rates, bear in mind the following: The relative price of a currency means an exchange rate. The euro – dollar exchange rate, for example, tells you how many euros to give up to buy one dollar. That exchange rate therefore implies the price of a dollar in euros.

It tells you how many dollars to give up to buy one euro if the exchange rate is expressed as the dollar – euro rate. That exchange rate therefore implies the price of a dollar euro. Some factors influence the demand and supply of dollars in foreign exchange markets, or of any other currency. The demand-supply model of exchange rate determination means that as the variables influencing demand and supply conditions change, the equilibrium exchange rate increases.

Such variables are divided into two areas in the demand – supply model, based on how they influence exchange rates. The rate of inflation and the rate of growth are considered factors relating to trade. When applying changes to exchange rates in one of these factors, you think about the trade between the US and the Eurozone. The interest rate, by comparison, is a factor related to portfolio flow. It means you think about how this move affects the attractiveness of dollar- and euro-denominated securities to American and European investors when one of the country's interest rates increases.