Supply and Demand

• the greater the supply of a currency, the lower its price
• the lower the supply of a currency, the higher the price
• the greater the demand for a currency, the higher its price
• the lower the demand for a currency, the lower its price
• four factors that influence the supply and demand for a currency:

  1. economic growth
  2. inflation and interest rates
  3. market psychology
  4. government action
• economic growth: increase in value of the goods and services an economy produces
• economic growth measured as the annual increase in real GDP in which inflation rate is subtracted from growth rate
• economic growth results from innovation and entrepreneurship
• to accommodate economic growth, the central bank increases the nation's money supply, increasing the supply and demand of the nation's money supply and by extension the nation's currency
• central bank: monetary authority in each country that regulates the money supply, issues currency, and manages the exchange rate of the nation's currency relative to other currencies
• recent rapid economic growth in East Asian countries has increased demand for their currencies by firms and individuals, domestic and foreign
• inflation: increase in price of goods and services
• Argentina and Zimbabwe have had prolonged periods of hyperinflation
• hyperinflation: persistent annual double digit and sometimes triple digit rates of price increases
• interest rates and inflation are closely related; in countries with high inflation, interest rates tend to be high because of compensation reasons
• when inflation occurs, money buys less than in preceding years
• inflation occurs when demand for money grows more rapidly than supply, or when central bank increases nation's money supply faster than the rise in national productive output
• annual inflation in Brazil ran to more than 1000% in the mid 1990s
• market psychology: unpredictable behavior of investors
• herding: tendency of investors to mimic each others' actions
• momentum trading: investors buy stocks whose prices have been rising and sell stocks whose prices have been falling
• herding and momentum trading tend to occur during financial crises
• in Brazil and Russia, there's been a large scale flight of portfolio investment amid concerns about deteriorating economic conditions
• the Chinese government regularly intervenes in foreign exchange market to keep renminbi undervalued helping ensure exports remain strong
• devaluation: reduces official value of a currency relative to other currencies
• an undervalued currency can result in a trade surplus
• balance of trade: difference between monetary value of nation's exports and its imports over the course of a year
• devaluation: government action to reduce official value of its currency relative to other currencies; potentially reduces trade deficit
• balance of payments: nation's balance sheet of trade, investment, and transfer payments with the rest of the world; represents the difference between the total amount of money coming into and going out of a country