Supply and Demand in Foreign Exchange

A par is a theoretical or abstract rate and is, of course, not necessarily the rate at which a currency can be bought or sold.

The actual, or market, rates of exchange tend to fluctuate around the official par only when the par approximates an equilibrium rate. If the par overvalues the currency, the market rates tend to fluctuate below it; if it undervalues the currency, they tend to fluctuate above it.

Foreign exchange, or the currency of another country, is usually wanted, not for itself, but for what it will buy in its country of issue. An obvious exception is foreign exchange wanted for speculative purposes.

Thus, the demand and supply of foreign currencies may be said to be derived from that of the items bought and sold with it. In addition, the supply of foreign currencies comes from many different sources and may be said to represent a composite supply.

Under these circumstances the demand for and supply of foreign exchange rates takes on the characteristics of the goods, services, and capital that it is desired to acquire or that gave rise to the supply. As far as the establishment and maintenance of parity is concerned, the price elasticity of the goods, services, and capital from which the demand and supply of foreign exchange rates are derived are matters of prime importance.

The price elasticity of the demand for foreign exchange refers to the response of buyers to a change in the rate of exchange, demand is considered elastic. If, on the other hand, buyers react slightly to changes in exchange rates, demand is held to be inelastic.

The supply of foreign exchange of a given country stems from the sale of foreign merchandise, services, and capital to that country. When foreigners want to buy a country's exports, they must purchase it currency with their own. Thus the supply of one country's currency available to a second country is closely related to the demand for the second country's currency. When the demand schedule of a given country for a foreign currency is known, the supply schedule of the foreign country's exchange can be frequently derived from it.

Similarly to the price elasticity described earlier, the supply elasticity of foreign exchange refers to the responsiveness of sellers to movements in the rates or pars of exchange. When the sellers are highly responsive to those changes, the supply is said to be elastic; when they are not, the supply is inelastic.

For purposes of determining its elasticity, the supply is generally divided into two groups: an existing or market and a long-run supply. The market supply cannot be increased immediately and is therefore likely to prove inelastic. A long-run supply must be produced, and its price elasticity may depend on the nature of the costs involved in creating additional supplies of it.

From that point of view, supply elasticity is related to the cost of production of exports, since, for most countries, the largest share of foreign exchange is that gained by the export of merchandise and services. When the supply of foreign exchange is derived from constant-costs industries (labor- intensive ones), the supply price is not likely to change much as the quantity demanded rises and falls.

Furthermore, the supply prices of increasing-costs industries (land-intensive ones) tend to rise when demand increases and to fall as demand decreases. When the supply is derived from decreasing-cost industries (capital-intensive ones), the supply price tends to decrease when the quantity demanded increase, and vice-versa.