Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- The foreign exchange market is where one currency is traded for another. Its price is the exchange rate.
- With a flexible rate, the market sets the rate where quantity demanded equals quantity supplied.
- Demand for valdas comes from people buying Valdorian exports, services (such as tourism) and financial assets. It is a derived demand.
- Supply of valdas comes from Valdorians paying for imports, travel abroad and foreign assets.
- A cheaper valda makes Valdorian goods cheaper abroad, so more valdas are demanded (downward slope).
- A dearer valda makes foreign goods cheaper for Valdorians, so more valdas are supplied (upward slope).
- Movements toward equilibrium are movements along the curves. Shifts are Topic 6.4.
Key relationships
| Idea | Rule | Use it to |
|---|---|---|
| Axes for the market for valdas | vertical: OS per VD; horizontal: quantity of VD | label the graph |
| Equilibrium | quantity demanded = quantity supplied | find the equilibrium rate |
| Surplus | quantity supplied − quantity demanded (rate above equilibrium) | predict depreciation |
| Shortage | quantity demanded − quantity supplied (rate below equilibrium) | predict appreciation |
| Reciprocal rate | VD per OS = 1 ÷ (OS per VD) | switch to the other currency’s market |
| Linked markets | supply of VD = demand for OS; demand for VD = supply of OS | answer about either currency |
Assumptions behind the model
- Two currencies only (valda and ostro), so “the other currency” is clear.
- The exchange rate is flexible: no government sets it.
- Everything except the exchange rate is held constant when you move along a curve.
Mistakes to avoid
- Labelling the vertical axis just “price” or using the wrong ratio (VD per OS in the valda market).
- Saying Valdorians demand valdas in this market. They mostly supply them.
- Saying a surplus raises the rate. It lowers it.
- Shifting a curve because the exchange rate changed. That is a movement along.
- Measuring a surplus or shortage vertically instead of as a quantity of currency.
- Assuming the two currencies change by the same percentage.
Quick self-check
Valdoria (currency: valda, VD) and Ostria (currency: ostro, OS) are the fictional countries used in the study guide.
- At OS 1.8 per valda, 70 million valdas are demanded and 95 million supplied. What is in the market, and which way does the rate move? (A surplus of 25 million VD; the valda depreciates.)
- A Valdorian buys Ostrian shares. Does she demand or supply valdas? (She supplies valdas and demands ostros.)
- One valda is worth OS 1.25. What is one ostro worth in valdas? (VD 0.80)
Next: practice questions.