Note: I will use the market US Dollars relative to Mexican Pesos as my example for simplicity, but these concepts apply equally to any two currencies.

Axes: The “y” axis on the foreign exchange market is the “Exchange rate in Pesos,” “Pesos per Dollar,” or my preference, “Price of Dollars in Pesos.”

The “x” axis is the quantity of US Dollars.

Just like every other market, where the two curves intersect you find the equilibrium price and equilibrium quantity. In this case, the price is called the exchange rate. When the exchange rate increases,the currency appreciates. When the exchange rate falls, the currency depreciates.

Determinants of Currency Demand: There are 3 determinants of demand for a currency (shifters). The first is the demand for a country’s exports. If the demand for a country’s exports increase, the demand for the currency also increases (causing the currency to appreciate). If demand for exports decrease, demand for the currency also decreases (causing the currency to depreciate). Some factors that influence the demand for a country’s exports include price levels (lower price levels, higher demand), foreign national income (more foreign income, more demand), and foreign consumers tastes and preferences.

The second determinant of demand is interest rates. These interest rate changes could come from the loanable funds market or the money market . If the US interest rate increases relative to Mexico, the demand for US dollars will increase as foreign investors purchase dollars to invest in the US seeking a higher rate of return. At the same time the demand of Mexican Pesos (in the market for pesos) will decrease as foreign investors will demand fewer pesos to invest in Mexico. This will cause the US dollar to appreciate while the Mexican Peso depreciates.

The third determinant of demand is the expected future exchange rates. Higher future exchange rates increase demand and lower expected future exchange rates decrease demand.