Money, Banking, and International Financefunction increases, shifting rightward, decreasing the market price. Thus, the U.S. dollar
depreciates while Malaysian ringgit appreciates.
Price of U.S. dollar
Ringgits per U.S. dollar
Quantity of U.S. dollars
Figure 6. The Federal Reserve increases the supply of dollars on the exchange market
A central bank holds foreign currencies. If a central bank wants to strengthen its currency, it
must buy its currency using a foreign currency. Consequently, a central bank’s cache of foreign
currencies would decrease. If a central bank weakens its currency, subsequently, it buys foreign
currencies using its own currency. Hence, a central bank accumulates more foreign currencies.
The key is scarcity. If the exchange market has little of a country’s currency, then the currency
becomes more scarce. Consequently, investors, central banks, and people value it more.
If investors believe a currency will depreciate, then their beliefs become self-fulfilling
prophecies. For example, we depict the international currency market for U.S. dollars in Figure
- Unfortunately, the investors believe the U.S. dollar will depreciate. Consequently, the
investors reduce their demand for U.S. dollars and shift the demand leftward, decreasing the
exchange rate. Thus, the U.S. dollar depreciates while the euro appreciates. Investors’ beliefs
turned into reality. In a worst-case scenario, a depreciating currency triggers a capital flight.
International investors withdraw their investments from a foreign country, collapsing its
currency and creating a severe financial crisis for the country.
Supply and demand analysis could be ambiguous in some cases. For example, Malaysia’s
GDP grows faster than U.S. GDP. Malaysian citizens experience growing incomes and would
increase their demand for all products, including imports. Thus, Malaysian citizens increase
their demand for U.S. dollars, increasing the supply of ringgits on the currency exchange
market. U.S. dollar appreciates while the ringgit depreciates. A rapidly growing country
experiences greater inflation, which causes its currency to depreciate. However, a prospering
country tends to have higher interest rates, which has the opposite effect on the market.