Supply and demand is the fundamental principle that controls most markets in the world. Whether it’s gold, oil, currency, or the latest must-have Christmas toy, its supply (how much of a particular item or commodity is available at any one time) and demand (how desirable something is to a particular market or segment of the population) are used to determine its relative value.
In its most basic terms, as supply goes up, demand goes down, and vice versa. Remember Cabbage Patch Kids in the 1980s? When they became the “it” gift, their demand went sky high, and supplies became very low. Parents were paying ten times the actual value as a result (if they managed to find one for sale). As demand goes up, so too does its value.
The currency market works the same way. Supply and demand are used to help determine a currency’s relative value.
The Supply and Demand Seesaw
The simplest way to determine a particular currency value (or to predict its future value in the Foreign Exchange, or Forex, Market) is to utilize the supply and demand seesaw. With it, you can get a quick indication whether it’s going to get more valuable, or less. There are, of course, no guarantees, but it does give a relatively reliable visual cue.
On the left hand side of the seesaw, you place the fundamental factors that either decrease the supply of a currency, or increase its demand. Anything that will increase supply or decrease demand goes on the right. As you add items to either the left or right, one side will eventually dip down because it is heavier than the other. If the left side (less supply, higher demand) goes down, your seesaw rises from left to right, indicating that the currency will likely RISE in value. If the right side sinks, your seesaw falls from left to right, indicating a possible fall in value of the currency in question. That’s the supply and demand seesaw at its most basic.
Fundamental Factors that Affect the Supply and Demand
There are a number of things that could affect the overall supply and demand of a particular currency (to be placed on either the left or right of the seesaw). These include:
- Consumer Spending - at certain times of the year (like the month before Christmas), people spend much more than usual. They need more money. Individuals may elect to “cash in” stocks and bonds, for example, in order to access money for their purchases. This is a classic example of increased demand (more people need the currency) and decreased supply (more of it being withdrawn). The exact opposite could happen during times of economic hardship, like a recession or very high unemployment. People spend - and therefore need - much less. Demand goes down, supply goes up.
- Trade Balance - to calculate the basic trade balance for a given country, look at the total IMPORTS and EXPORTS. If they have more going out (exports) than coming in (imports), they have a positive trade surplus. This is a positive, and may lead to greater demand for that currency. Alternatively, higher imports than exports leads to a trade deficit, and investors may be less likely to demand that currency.
- Political and Natural Events - military coups, war, rebellion, and natural disasters can all affect the supply and demand of currency in a negative way. Instability of any kind causes people to lose faith (decreased demand) in that particular currency, or decrease the available supply as money is funneled to financing a war or rebuilding after a disaster. But it can work the other way, too. A recent election that sees a powerful, fair, and strong government replace a corrupt one may lead to much higher demand for that currency. Foreign entities may want to invest domestically in the newly stable region, for which their need the local currency. The discovery of new natural assets (oil, gold, diamonds, etc.) could also lead to greater foreign investment and purchase of goods, both of which lead to increased demand of the currency.
- Interest Rates - this one could be good or bad depending on the situation. Lower interest rates on stocks and bonds, for example, may indicate a decrease in overall supply, as people convert to money (for a variety of reasons). The interest rate in a given country is directly controlled by its central or main bank. Decisions (or even rumours) to raise or lower it can quickly affect supply and demand.
- Commodity Prices - as certain items become more or less expensive, this can affect different countries (and therefore the supply and demand of their currency on the Forex) in different ways. An increase in the cost of oil, for example, may benefit countries that export it (such as Canada or Venezuela), while working against countries that import the bulk of it (like the USA). In this example, the Canadian dollar could see a spike in demand (and value), while the American dollar may lose some of its appeal (and value).
These are just a few examples. There are others, and it can become quite convoluted and complicated while trying to accurately gauge the supply and demand. The supply and demand seesaw, though, does give a quick picture. While it wouldn’t be a great idea to rely ONLY on that, it does give a snapshot. Many things affect the relative value of a given currency, not just one or two. You need to really follow, read, and understand the country in question - as well as international finance in general - to get the big picture.
Photo by Pulkit Sinha
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