Education > Forex - Step8
[SECTION 3.2]
Capital and trade flow drive currency values
Supply and demand are the principal drivers underpinning all price movement in the forex market. Understanding capital and trade flow is the key to measuring supply and demand..
Capital flow measures the money that flows in and out of an economy for investment purposes such as buying stocks and bonds or merging with or acquiring another company.
Trade flow measures that money that flows in and out of an economy for the purchase of tangible goods and services such as cars, electronics and professional services.
As money, be it for investments or for goods and services, flows in and out of an economy, the supply of and demand for that economy's currency goes up and down. This causes the value of that currency to fluctuate as well.
In this section, we will examine how the following affect the supply of and demand for a currency:
- Capital flow [SECTION 3.2.1]
- Trade flow [SECTION 3.2.2]
[SECTION 3.2.1]
Capital flow
Money traverses borders daily in ever-increasing amounts. Globalisation has made it eadier and easier for investors to let their money work in virtually any economy around the globe, regardless of where they live. Investing in stocks on the New York Stock Exchange (NYSE) or the NASDAQ is just as easy as investing in stocks on the London Stock Exchange (LSE), the Frankfurt Stock Exchange or the Tokyo Stock Exchange.
Global investors subsequently influence the levels of supply and demand for currencies around the globe. Let's see how their actions impact on the value of a currency.
Here is a classic supply and demand chart (see figure 1). You can see that demand is represented by the line that slopes downward from left to right, and supply is represented by the line that climbs upward from right to left. The point at which these two lines meet is the price the market will accept for the currency.
Figure 1-Supply and demand chart
The flow of capital from economy to economy affects the currencies of the two countries involved in the exchange. Take a look at how the following can impact the value of a currency:
- Increasing demand [SECTION 3.2.1.1]
- Increasing supply [SECTION 3.2.1.2]
- Decreasing demand [SECTION 3.2.1.3]
- Decreasing supply [SECTION 3.2.1.4]
[SECTION 3.2.1.1]
How increasing demand affects currency values
Increased demand for a currency boosts the value of that currency.
In the supply and demand chart below (see figure 2), you can see that as demand grows, the demand curve shifts farther and farther to the right of the chart. As it shifts right, the point at which the demand curve meets the supply curve also moves higher and higher. This tells you that stronger demand for a currency strengthens the value of that currency.
Figure 2-Supply and demand chart (increased demand)
Demand for a currency rises as investors take their money from one economy into the economy represented by that currency. For example, when investors in Japan want to buy U.S. government bonds, they must exchange their Japanese yen (JPY) for U.S. dollars (USD). This strengthens demand for U.S. dollars simultaneously increasing its value.
Extra material / cut outs
Market manias are often induced by illogical increases in demand. One famous example of this is the Dutch Tulip Mania of the 17th century. Tulips were introduced to the Netherlands in the late 1500s by traders returning from the Ottoman Empire (Turkey). By the early 1600s, tulips?especially rare bulbs?were trading at astronomically high prices. The most expensive recorded sale was 6,000 florins for a Semper Augustus bulb. To put this in perspective, average annual income at the time was around 150 florins. Never underestimate the effect of increasing demand. (WHAT ABOUT SAYING WHAT SUBSEQUENTLY HAPPENED TO THE MARKET? DIDN'T THE BOTTOM FALL OUT OF IT EVENTUALLY WITH LOTS OF PEOPLE LOSING VAST SUMS?)
[SECTION 3.2.1.2]
How increasing supply affects currency values
A rise in the supply of a currency leads to a fall in value of that currency.
The supply and demand chart below (see figure 3), illustrates that as supply goes up, the supply curve shifts to the right. As it moves farther and farther right, the point at which the demand curve meets the supply curve also goes lower and lower. This tells you that increasing supply of a currency decreases the value of that currency.
Figure 3-Supply and demand chart (increased supply)
Supply of a currency strengthens as investors move their money from the economy represented by that currency into another economy. For example, when investors in Japan want to buy U.S. government bonds, they must exchange their Japanese yen (JPY) for U.S. dollars (USD). This increases the supply of Japanese yen (JPY), which leads to a fall in the yen's value.
[SECTION 3.2.1.3]
How decreasing demand affects currency values
A fall in demand for a currency decreases the value of that currency.
Take a look at the supply and demand chart below (see figure 4). You can see that as demand slips, the demand curve shifts farther and farther to the left on the chart. As it moves farther and farther left, the point at which the demand curve crosses the supply curve also moves down. Decreasing demand for a currency clearly weakens the value of that currency.
Figure 4-Supply and demand chart (decreased demand)
Demand for a currency falls as investors stop moving their money from other economies into the economy represented by that currency. For example, when the Bank of England (BOE) lowers interest rates, U.K. government bonds subsequently have less appeal to foreign investors as the rate of return falls. If foreign investors stop buying U.K. government bonds, then they will no longer swap their currency for British pounds (GBP). This decreases demand for British pounds (GBP) and weakens the pound's value.
[SECTION 3.2.1.4]
How decreasing supply affects currency values
A fall in the supply of a currency boosts the value of that currency.
The supply and demand chart below (see figure 5) shows that as supply falls, the supply curve shifts farther and farther to the left. As this happens, the point at which the demand curve hits the supply curve moves higher and higher. This shows that falling supply of a currency raises the value of that currency.
Figure 5-Supply and demand chart (decreased supply)
Supply of a particular currency weakens when central banks raise reserve requirements to pull money out of circulation. For example, when the U.S. Federal Reserve increases reserve requirements for its member banks, it tells them that they must keep more of their money in reserve instead of making it available to borrowers. This makes it more difficult for corporations and individuals to borrow money, effectively cutting the supply of money in circulation.
[SECTION 3.2.1]
Trade flow
The chances are that if you look at any of the electronics, toys and clothing you bought during this past year, you will find they will have been made somewhere other than the country in which you live. Global trade has flourished, and it is now possible for virtually anyone to eat dates from Israel on dishes from Europe while watching a television made in China.
Trade flow between economies affects currency values. Every time goods or services exchange hands, money �exchanges hands too. European importers have to exchange money to buy goods from Japanese exporters just as Japanese importers have to exchange money to take goods from European exporters. Every time this happens, it influences the supply of and demand for the currencies of the two economies involved. And, as we already know, supply and demand drive currency prices.
In the classic supply and demand chart (see figure 6) below, demand is depicted by the line that slopes downward from left to right, and supply is the line that slopes up from right to left. The point at which these two lines intersect is the price the market will accept for the currency.
Figure 6-Supply and demand chart
Take a look at how the following can impact the value of a currency:
- Increasing demand for the exporter's currency [SECTION 3.2.2.1]
- Increasing supply of the importer's currency [SECTION 3.2.2.2]
You can also monitor what effects trade flow may have on the currencies you are trading by following the trade balance, the most important trade-based fundamental economic indicator. [SECTION 3.2.2.3]
[SECTION 3.2.2.1]
How increasing demand from importers affects currency values
A rise in demand for a currency boosts the value of that currency.
In the supply and demand chart below (see figure 7), you can see that as demand goes up, the demand curve shifts farther and farther to the right. Subsequently, the point at which the demand curve meets the supply curve also goes higher and higher. This tells you that strengthening demand for a currency increases the value of that currency.
Figure 7-Supply and demand chart (increased demand)
Demand for an exporter's currency rises as importers from one economy purchase goods and services from exporters in another economy. For example, when importers from the U.S. want to buy products from Japan, they must buy them in Japanese yen (JPY). Effectively, that means U.S. importers must buy Japanese yen (JPY) to buy Japanese goods. This boosts demand for Japanese yen (JPY) and raises the Yen's value.
[SECTION 3.2.2.2]
How increasing supply from importers affects currency values
A rise in the supply of a currency weakens the value of that currency.
The supply and demand chart below (see figure 8), shows you that as supply increases, the supply curve shifts farther and farther to the right on the chart. The farther right it goes, the lower will be the point at which the demand curve intersects the supply curve. Strengthening supply of a currency hits the value of that currency.
Figure 8-Supply and demand chart (increased supply)
The supply of an importer's currency goes up as importers from one economy buy goods and services from exporters from another economy. For example, when importers from the U.S. want to buy Chinese goods, they must buy those goods in Chinese yuan . To get the money to buy Chinese yuan, U.S. importers must first sell U.S. dollars (USD) and then use those proceeds to buy Chinese yuan. This sale of U.S. dollars (USD) lifts the supply of U.S. dollars (USD) simultaneously weakening its value.
[SECTION 3.2.2.1]
Trade balance
The trade balance measures the gap between imports and exports of tangible goods and services. The level of the trade balance and changes in exports and imports have a direct impact on foreign exchange markets.
The trade balance is a major indicator of likely developments in foreign exchange. Seen in isolation, measures of imports and exports are important indicators of overall economic activity in the economy.
A look at the trend growth rates for exports and imports separately is often revealing. Trends in export activities reflect not only the competitive position of any given country, but also the strength of its foreign economic activity. Trends in import activity illustrate the strength of domestic economic activity.
Typically, a nation with a substantial trade balance deficit has a weak currency due to the continued commercial selling of the currency. This can, however, be offset by financial investment flows for extended periods of time.  | 
