Exchange Rate Appreciation – Increased Demand and Reduced Supply of Currency
Global Economics
This diagram illustrates a general appreciation of a currency in the foreign exchange market. An appreciation occurs when the value of the currency rises due to an increase in demand and/or a decrease in supply of the currency.
Curves and Elements
demand currency
Demand for the currency (D$): Downward-sloping; a rightward shift indicates higher demand at each exchange rate.
supply currency
Supply of the currency (S$): Upward-sloping; a leftward shift indicates fewer units supplied at each exchange rate.
initial equilibrium
Ee: The original equilibrium exchange rate before the shifts in demand and supply.
new equilibrium
E1: The higher equilibrium exchange rate after the shifts, showing currency appreciation.
The initial equilibrium exchange rate is shown at Ee, where demand for the currency (D$) intersects supply of the currency (S$).
An increase in demand for the currency, shown by a rightward shift from D$ to D1$, may occur due to higher foreign demand for exports, capital inflows, or higher interest rates.
A reduction in the supply of the currency, shown by a leftward shift from S$ to S1$, may occur when imports fall, meaning fewer units of the currency are sold in foreign exchange markets.
The combined effect of higher demand and lower supply leads to a higher equilibrium exchange rate (from Ee to E1).
The rise in the exchange rate represents an appreciation of the currency.
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