Equilibrium and Disequilibrium in the Currency Market

Think of a currency market like any other market, except the thing being traded is money itself. People who want to buy a country's exports, invest in its assets, or hold its currency create demand for it. People in that country who want to buy foreign goods or foreign assets create the supply, since they must sell their own currency to get foreign currency. The exchange rate is just the price where that demand curve and supply curve cross. At any other price, one side wants more of the currency than the other side is offering, and that imbalance itself pushes the price back toward equilibrium.

Suppose dollars are in surplus: at the current rate, people are offering more dollars for sale than others want to buy. Sellers of dollars compete the price down, so the dollar depreciates, meaning it takes fewer units of foreign currency to buy one dollar, or more dollars to buy one unit of foreign currency depending on how you quote it. That depreciation makes dollars cheaper for foreigners, raises quantity demanded, and the market clears. A shortage works the same way in reverse, pushing the currency to appreciate.

A government or central bank can try to freeze the rate away from this natural level, usually to keep its currency artificially strong or weak for trade reasons. Doing so does not make the imbalance disappear; it just forces the central bank to buy up or sell off currency reserves to plug the gap, the same way a price ceiling on an ordinary good creates a shortage that persists until someone intervenes. This links directly to the next idea in the unit: sustained intervention drains or builds reserves and ties back into the balance of payments.