Foreign exchange market

The spot rate for any currency pair is determined in the foreign exchange market, sometimes abbreviated as the forex market. These are over-the-counter or instantaneous markets for the trading of currencies.

Collectively the market for foreign exchange is the largest market in the world. This is partially due to it operating in multiple cities across the globe and that it is a 24 hour market for the 5 days a week it is open, In total there was an average daily trading volume of $7.51 trillion in April of 2022 according to the Bank for International Settlements.

The foreign exchange market will have the quantity of the home currency traded on the x-axis and the exchange rate, expressed in unit of foreign currency per unit of home currency on the y-axis. For the rest of this subchapter, we will use the United States as the home country and Germany as the foreign country. Thus the units will be quantity of US dollars on the x-axis and the euro per US dollar exchange rate on the y-axis.

Supply

Supply of a currency can be thought of as coming from domestic demand for foreign transactions. These include international trade and international financial flows. The major categories are the purchases of goods and services, investment and capital purchases, and movement of savings.

To purchase a good from Germany you must exchange US Dollars for Euros (practically a bank or credit card company does it for you). The US Dollar value of that import is recorded in GDP for the US, the Euro value as an export in GDP for Germany. In short, supply comes from US demand for imports from the foreign country.

Similarly if a company chooses to invest in a country other than its home country, Funds must be exchanged from their home currency into the foreign currency in order to complete the transaction. When a company invests in itself or a company it has ownership in in a different country, that is referred to as foreign direct investment (FDI).

The final example is savings crossing a border. As has been true for our macroeconomic discussions, savings in this case includes any possibility that is not current consumption. For example a savings account, a government bond, or even the purchase of a stock. If a household in the United States wishes to save in the Germany, no matter if it is to hold it in a liquid account or to purchase a stock, bond or other financial instrument, they need to exchange US dollars for euros.

As the exchange rate rises the dollar appreciates. Because the dollar is stronger, all else equal any transaction in Germany is now relatively cheaper compared to the same transaction in the United States. We may also say that any activity is relatively more expensive in the United States compared to the same activity in Germany.

Thus the supply curve slopes upwards, because the exchange rate for the dollar appreciates and dollar holders wish to exchange their dollars for Euros to take advantage of the improved exchange rate.

Demand

Demand is nothing more than the reverse story. It comes from foreign demand for domestic transactions. Other than that, the categories are exactly the same, making up international trade and international financial flows. Trade in goods and services, investment and capital purchases, and movement of savings.

If a German resident purchases a US produced good, a US export, that requires the exchange of euros for US dollars. Similarly, if the German car company BMW wishes to built a car factory in the United States, that also requires euros being converted into dollars. It also counts as FDI for the United States. Finally, if a German resident moves funds to a savings account in the United States, purchases a US government bond or buys shares in the US stock market, euros must be converted to US dollars.

An appreciation of the dollar leads to a lower quantity demanded for dollars. As US dollar activities become relatively more expensive and German activities become relatively cheaper, Germans will keep more of their euros and demand fewer US dollars. This gives us the usual downward sloping demand curve for dollars.

The exchange rate of euros per US dollar (euro/US dollar) can be thought of as the price of US dollars, our quantity of interest. So a lower “price” leads to a higher quantity demanded and a lower quantity supplied. This is our usual law of demand and law of supply.

Equilibrium

Equilibrium in the foreign exchange market is determined by supply and demand.

[exchange rate graph]

Government or central bank actions may interfere, but we treat those as shifters for supply or demand instead of as breakdowns in market operations.

Shifters

With the basics of equilibrium in hand, we can now discuss the shifters of the curves.

Now let us discuss what the shifters are. For this table the exchange rate is expressed in units of foreign currency per units of the domestic currency.

Factor	Change	Shifts	Change in E
Real interest rates	Domestic real interest rate $\uparrow$	$S\leftarrow$ and $D\to$	$E\uparrow$
	Foreign real interest rate $\uparrow$	$S\to$ and $D\leftarrow$	$E\downarrow$
Relative prices	Domestic PL $\uparrow$	$S\to$ and $D\leftarrow$	$E\downarrow$
	Foreign PL $\uparrow$	$S\leftarrow$ and $D\to$	$E\uparrow$
Income level	Domestic income $\uparrow$	$S\to$	$E\downarrow$
	Foreign income $\uparrow$	$D\to$	$E\uparrow$
Tastes and preferences	Domestic desire for foreign $\uparrow$	$S\to$	$E\downarrow$
	Foreign desire for domestic $\uparrow$	$D\to$	$E\uparrow$

For the discussion, Let us take the example of the US as the domestic country and the Eurozone as the foreign country. Things that make activities in US dollars more attractive make the dollar stronger (euro weaker), and things that make activities in Euros more attractive make the euro stronger (dollar stronger).

A higher real interest rate in the US leads to a capital inflow. All else equal, funds from abroad will move in to take advantage of the higher returns. As a reminder, changes in the real interest rate could include changes in nominal interest rates or in the inflation rate.

If the US price level falls, that makes US goods and services more cheaper for everyone. Demand for US dollars increases because foreigners buy more US goods and services and the supply of US dollars decreases because domestic actors buy more US goods and services.

Increases in income lead to increased imports. Higher US income increases demand for imports from the Eurozone leading to an increased supply of US dollars. Similarly, higher European income increases demand for imports from the United States, leading to increased demand for US dollars.

Finally, we have tastes and preferences for the goods, services and investment products. Some country pairs will naturally have more trade or higher financial flows in one direction. For example, in smaller countries with less economic stability, there is often higher demand for a more stable currency such as the US dollar, British pound or euro.

The most common stories around changes in tastes and preferences are related to political stability and geopolitical events. Higher stability generally leads to more investment and higher returns.

Elections can sometimes lead to large changes in exchange rates, particularly if they lead to large changes in government policies. A recent example of this is the 2025 election in Argentina. Javier Milei was elected with promises of structural changes to the Argentine economy, including cuts in government subsidies and spending and changes in labor and tax laws. Part of his position was to devalue the Argentine peso and that plus the added uncertainty explains the sharp movement seen in 2023. In ____ 2025, his party won regional elections, providing some certainty that his policies would continue in the near term leading to an appreciation in the Argentine peso.

[ARS for Milei]

Notes of caution

The first complicated thing about the foreign exchange market is the need to take exceptional care of the units of the exchange rate. If it is euros per US dollar, then US dollars are the focus. Demand is from the Eurozone and supply is from the US. If the rate is instead in US dollars per euro, then euros are the focus. Demand is from the US and supply is from the Eurozone.

Thus it can be seen that the supply of US dollars is connected to demand for euros, and the demand for US dollars is connected to the supply of euros. They are not exactly equal, but in our stories their shifts are.

The second complicated thing about this market is that most of our shifters apply to both supply and demand at the same time. This is a serious breakdown of the ceteris paribus assumption. Everything else can never be equal. Luckily, the shifts combine so that the quantity traded is ambiguous but the change in the exchange rate is known.

There are a few ways to treat these double shifts in something like a free response question (FRQ). You may assume that the shifts to supply and demand are equal in size, and thus that the total quantity traded in equilibrium remains the same. Or you may tell a story where one curve shifts more than the other. The safest choice there is to focus on the domestic effect (supply of the home currency) and tell that story.

*As long as your explanations match up with the graph and fit the prompt, any choice is acceptable. *