The Foreign Exchange Market

A currency gets a supply and demand curve for the same reason wheat does: people want to acquire it, and other people are willing to give it up, at a price. The price here is the exchange rate, say euros per dollar. Demand for dollars comes from foreigners who need dollars to buy American exports, American bonds, or American real estate and factories. Supply of dollars comes from Americans who hold dollars but want euros instead, to buy European goods or European assets. Graph it with the exchange rate on the vertical axis and the quantity of dollars on the horizontal axis: demand slopes down, supply slopes up, and they cross at the equilibrium exchange rate.

The key mistake to avoid: demand for a currency is not the same as demand for that country's goods. Goods exports are only one source of currency demand. A foreign investor who wants no American products at all will still demand dollars if American bonds pay high interest, because buying that bond requires dollars. That is why a central bank raising interest rates can drive up its own currency's value purely through financial inflows, with exports untouched.

This market is the hinge of the whole unit. When a country's interest rates rise, demand for its currency rises, its currency appreciates, and that appreciation makes its exports more expensive and imports cheaper, shrinking net exports. So the loop running through this unit goes: interest rates move capital flows, capital flows move the exchange rate in this market, and the exchange rate moves net exports and real GDP.