Question

what are the major factors that determine foreign exchange demand and supply? A) Who supplies an demands foreign currency? b) analyze the effect of; b.1- increase in government spending b.2- decrease in central bank money on the value of Turkish lira (exchange rate)

Answer 1

Major factors determining foreign exchange demand and supply:

• Inflation levels. A currency with low inflation exhibits a higher demand for currency because of the surge in purchasing power. The supply increases to reach the equilibrium.
• Higher interest rates. This attracts foreign investments and thus the exchange rate becomes strengthened thus the demand of currency increases as well.
• Balance of payments. A scenario in which exports exceed more than imports means the trade is healthy means the demand for Turkish lira increases.

The demand and supply of foreign currency happens primarily through international trade. If a country X buys some goods from country Y, there is a cash flow from X to Y and this comprises the foreign exchange. The demand is made by Y and currency is supplied by X.

b1)

The government expenditure mentioned here shall be through expansionary fiscal and monetary policies. With the advent of these policies, the consumer spending increases as well. The demand for imports increase as the consumer is now willing to spend on more things. Thus due to this surge in demand, the exchange rate falls thus leading us into a situation where we can perceive a weak exchange rate.

b2)

When there is a decrease in central bank money, they impose higher interest rates to make up for the cash crunch faced at the moment. When a higher interest rate is set, foreign investors are attracted to invest seeing forecasting healthy returns in Turkey. Thus the exchange rate strengthens or increases due to the increased foriegn investment.

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