Factors Effecting Currencies - Economic Theory

In economics, the laws of supply and demand are ever-present, and currency trading provides a prime example of this law in action. Just like the value of a good is determined by the supply and demand for that good, the value of a nation's currency is determined by the supply and demand for that currency.

The law of demand says that the demand for a good fall as the price rises and increases as the price falls, meaning that price and demand are inversely related.

The law of supply, however, says that the quantity of a good supply rises as the market price rises and falls as the price falls, meaning that supply and price are directly related.

The supply of foreign exchange comes from foreign demand for U.S. dollars. When people or businesses from foreign countries desire to purchase American products, they have to purchase dollars first for buying the goods. More demand for U.S goods, for example, would change the demand for the U.S dollar. A significant increase in the overseas demand for US products will have the effect of driving up the value of the dollar.

Let’s take a closer look on several consequences of supply and demand on the dollar’s value:

Demand for dollars

It is evident that whenever financial markets experience uncertainty all sort of companies, banks and investors flock to the dollar. In spite of this, many countries accept dollars as a physical currency, and therefore they need more supply of USD. The demand is coming from all sorts of sources such as banks, issuers of dollar-denominated debt, investors selling dollar-based assets, companies looking for cash for U.S. operations, and foreign banks looking to help customers. All of them are pressuring the currency.

Increase in money supply

With every new dollar printed, each one is valued less than before. The more dollars in circulation, the less valued the currency is because the supply has been boosted. This typically triggers inflation, which directly cuts into the dollar's value. Although this would seem difficult to calculate, M2 and M3 data reports on the US money supply are regularly released by the Federal Reserve.

By Adil Maidanov | 16 October 2020

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