Question

What are the factors that determine the shape and slope of the demand curve for foreign exchange in a flexible exchange rate system?

Short answer

Answer: The main factors influencing the shape and slope of the demand curve for foreign exchange in a flexible exchange rate system include relative prices of goods and services, real interest rate differences, expected future exchange rates, inflation rates, and economic stability and growth. The demand curve is usually downward-sloping, meaning that as the exchange rate increases, the quantity of foreign currency demanded decreases. The slope of the demand curve represents the responsiveness of the quantity of foreign exchange demanded to changes in the exchange rate (price) and generally depends on how sensitive people are to changes in the mentioned factors.

Step-by-step solution

Understand flexible exchange rate system

The flexible exchange rate system allows the value of a currency to be determined by market forces, i.e., supply and demand. As the exchange rate reaches new equilibriums based on these forces, the demand curve for foreign exchange is created, with the x-axis representing the quantity of foreign currency demanded and the y-axis representing the domestic currency's price per unit of foreign currency.

Factors influencing the demand for foreign exchange

The main factors that affect the demand for a foreign currency are: 1. Relative prices of goods and services: If a country's goods or services are cheaper than those of other countries when considering the exchange rate, the demand for its currency will increase, as foreigners will purchase that currency to acquire goods or services from that country. 2. Real interest rate differences: If the real interest rate is higher in a country, it tends to attract more foreign capital, which increases the demand for that currency. 3. Expected future exchange rates: If people predict that the value of a currency will appreciate in the future, they might want to buy it now, leading to increased demand for that currency. 4. Inflation rates: A low inflation rate in a country can increase the demand for its currency, as the real value of the currency tends to be more stable. 5. Economic stability and growth: Countries with stable economies and higher GDP growth rates typically attract more foreign investment, leading to an increased demand for their currency.

Shape of the demand curve

The demand curve for foreign exchange is usually downward-sloping, which means that as the exchange rate increases (i.e., domestic currency becomes stronger or more expensive), the quantity of foreign currency demanded decreases. The rationale behind this is that, when the domestic currency becomes stronger, goods and services from that country tend to become more expensive for foreigners, reducing their demand for that country's currency. Similarly, if domestic currency becomes weaker (less expensive), the demand for foreign currency increases due to the cheaper goods and services.

Slope of the demand curve

The slope of the demand curve represents the responsiveness of the quantity of foreign exchange demanded to changes in the exchange rate (price). In other words, it reflects the sensitivity of the demand for foreign currency to its price, captured by the concept of the price elasticity of demand for foreign exchange. The more responsive the demand for foreign currency to changes in its price, the flatter (or more elastic) the slope of the demand curve. Conversely, if the demand is less responsive to price changes, the slope of the demand curve will be steeper (or less elastic). The sensitivity of the demand for foreign currency to changes in its price generally depends on how sensitive people are to changes in relative prices, interest rates, inflation rates, economic stability, and growth.