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Forex Essentials Course: 21 lessons to get started in Forex

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2. Supply and Demand

Fri, Oct 24 2008, 14:20 GMT
by PFX Team

LearningMarkets.com

Supply and demand drives the forex market

The Forex market, just like every other market in the world, is driven by supply and demand. In fact, understanding the concept of supply and demand is so important in the Forex market that we are going to take a step back into Economics 101 for a moment to make sure we’re all on the same page.

Having a good grasp on supply and demand will make all of the difference in your Forex investing career because it will give you the ability to sift through the mountain of news that is produced every day and find those messages that are most important.

Supply is the measure of how much of a particular commodity is available at any one time. As the supply of a currency increases, the currency becomes less valuable. Conversely, as the supply of a currency decreases, the currency becomes more valuable.

Think about rocks and diamonds. Rocks aren’t very valuable because they are everywhere. There is a large supply of rocks in the world. You can literally walk down the street and have your choice of hundreds and thousands of different rocks. Diamonds, on the other hand, are expensive because there aren’t that many of them in circulation. There is a small supply of diamonds in the world, and you have to pay a premium if you want one. It's a crude analogy, but the point is made.

On the other side of the economic equation, we find demand. Demand is the measure of how much of a particular commodity people want at any one time. Demand for a currency has the opposite effect on the value of a currency than does supply. As the demand for a currency increases, the currency becomes more valuable. Conversely, as the demand for a currency decreases, the currency becomes less valuable.

To get a good idea of the effects demand can have on something’s value, you have to look no further than Tickle Me Elmo. When Tickle Me Elmo was first released, there was an insanely high demand for the toy. For those who weren’t fast or aggressive enough to get Tickle Me Elmo at the store, paying outrageously high prices on eBay was their last resort. Huge demand had made this red, giggling doll much more valuable than it would have been if nobody’s kid wanted it for Christmas.

To illustrate how supply and demand interact to determine an ideal exchange rate in the Forex market, we are going to use a standard supply and demand graph. Supply is represented by a diagonal line that is sloping up from a low point at the left end of the line to a high point at the right end of the line. Demand is represented by a diagonal line that is sloping down from a high point at the left end of the line to a low point at the right end of the line. Finally, the ideal exchange rate is represented by the point where the two diagonal lines intersect.

We determine the exchange rate by looking at the y-axis (the vertical axis). In this case, the supply and demand graph indicates that the ideal exchange rate for the EUR/USD pair is $1.21.

As we discussed, as supply increases, the ideal price decreases. You can see that as the diagonal supply line moves farther and farther right as supply increases, the intersection of the two lines moves lower and lower on the y-axis. This tells us the ideal exchange rate is getting lower and lower.

Conversely, as the diagonal line moves farther and farther left as supply decreases, you can see that the intersection of the two lines moves higher and higher on the y-axis. This tells us the ideal exchange rate is getting higher and higher.

Moving the diagonal demand line up and down will have similar effects on the exchange rate. As demand increases, the ideal price increases. So when you move the diagonal demand line higher on the graph—indicating an increase in demand—the intersection of the two diagonal lines moves higher and higher.

You can also see how the intersection of the two diagonal lines moves lower and lower as you move the diagonal demand line lower on the graph. As demand decreases, the ideal prices decreases with it.

The instances where you see a dramatic shift in the ideal price level come when both the supply and demand lines are moving. For instance, if demand for a currency suddenly increases while supply is decreasing, the ideal price level will climb very quickly.

On the flip side, if demand for a currency suddenly falls off while supply is increasing, the ideal price level will fall just as quickly. Supply and demand work efficiently in tandem.

Understanding the movement of the Forex market is relatively simple because the same forces of supply and demand you experience in your life every day play a significant role in determining the exchange rates in the Forex market.

Japan as an illustration

Take oil prices for example. When demand for oil goes up or the supply of oil drops off, oil prices go up. As oil prices go up, gasoline and natural gas prices go up. As gasoline and natural gas prices go up, you end up spending more to drive around town and to heat your home. And as you spend more and more on oil-based products, your budget gets leaner and leaner. Well, these same factors that affect your budget affect the budgets of the world’s largest corporations and governments.

One country that suffers from rising oil prices just like you do is Japan. Japan imports nearly 100 percent of its oil. It doesn’t have much of a choice. Japan isn’t known for its booming oil reserves. So any oil Japan wants to use to produce electronics, cars, and other goods, it must buy it at whatever the going rate is. But that’s just the beginning. Japan’s economy relies on its ability to export the goods it creates to other countries, like the United States. As you’ve noticed driving around town, it costs a lot of money to transport your groceries, your kids, and yourself from one place to another. It costs even more when you have to ship your goods across the Pacific Ocean. Every car, DVD player, and computer Japan produces is becoming more and more expensive to ship to consumers. So when you look at it, Japan is getting hit on both sides. It has to import all of its oil at inflated prices, and then it has to turn around and pay inflated prices to ship all of its goods.

So what impact does all of this have on Japanese goods? It makes them more expensive. If Japanese companies have to pay more to produce their products and then have to pay more to distribute their products, they are going to have to charge more for their products to cover their expenses and make a profit. As products become more and more expensive, consumers are able to buy less and less. And as consumers buy less, companies make less, which leads to all sorts of economically negative outcomes. Now, let’s take a step back now and look at what all of this has to do with the exchange rate of the Japanese yen.

Looking through the lens of supply and demand, you can see how an increase in the price of oil would affect the value of the Japanese yen. Oil is priced and sold in U.S. dollars. As oil becomes more expensive, purchasers in Japan have to convert more and more of their Japanese yen into U.S. dollars so they could pay for their oil. This would increase the supply of Japanese yen in the Forex market and subsequently lower the value of the Japanese yen. To compound the problem, as Japanese goods become more expensive and fewer and fewer people can afford to buy them, demand for Japanese yen falls. The fewer products you buy, the fewer Japanese yen you need. And when you don’t need something, you stop demanding it. Rising supply plus falling demand equal a decrease in the value of the Japanese yen.

The price of oil and its effect on the Japanese yen is just one example of how supply and demand impacts the Forex market. We will be looking at many other fundamental factors that influence the Forex market in the coming lessons. But the important thing now is that you feel comfortable with the concept of supply and demand.

Always be thinking Supply and Demand in your analysis

Every time you analyze the Forex market, all you have to do is ask yourself how supply and demand are going to be affected by what is going on. This holds true for both fundamental and technical analysis—the two major disciplines in the Forex market and every other market, for that matter.

Fundamental analysis is the study of what is happening in the world around us. Everything we have discussed so far in this book and will continue to discuss, from oil prices to stock market performance, relates to fundamental analysis.

Technical analysis is the study of what is happening on the chart of a particular currency pair. We will be discussing a few basic tenets of this investment art in a later lesson.

But both forms of analysis are built upon a foundation of supply and demand, so get ready to ask yourself supply-and-demand-related questions a lot. We'll now look at more illustrations and examples in the video.

Forex Essentials Course - 21 lessons:

Published on  Tue, Nov 18 2008, 17:09 GMT