The impact of supply and demand on the exchange rate

The exchange rates of currencies are affected by many factors like inflation, economic stability, interest rates, government intervention and monetary policies. These factors influence the supply and demand for a particular currency and the exchange rate is affected as a result. Generally, a currency that is in high demand has a more valuable x-rate with foreign currencies. On the other hand, a currency that has a large supply will not have a great of an exchange rate with other currencies.
Trading Currencies

The forex market can be a complex arena. Forex trading involves the relationship between one currency to another and this is why currency quotes are given in pairs. The currency market frequently uses the U.S. dollars to quote currency pairs because it is accepted worldwide. For example, a quote for the currency pair EUR/USD is 1.3428 meaning that 1 euro costs 1.3428 dollars. Other examples of currency pairs are GBP/USD (British pound and U.S. dollar) and USD/JPY (U.S. dollar and Japanese yen).
Supply & Demand

The fundamental law of supply and demand is relevant in the currency market just as it is to services and good. Currencies that are in high demand have a higher value than currencies that are in low demand. In addition, a large currency supply will reduce its price. The forces of demand and supply are complex and are influenced by many players including consumers, governments, corporations and foreign investors. As an example, the increase in the U.S. dollar may be due to a greater demand by foreign investors who purchase U.S. financial instruments like bonds and stocks.
Intervention by the Government

Government intervention can directly impact the demand and supply of a currency, thus affecting the price of the currency in the markets. Governments may choose to intervene in order to protect their interests. For example, the Japanese government decided to exchange 4.5 trillion yen for U.S. dollars in 2011 in order to keep the price of the yen low. In this case, the Japanese government wanted to stop the price of the yen from increasing in order to keep its exports prices low. On the other hand, the purchase of U.S. dollars by the Japanese government reduced the supply of the dollar and increased its value.
Economic Factors

There are several economic factors that affect the demand and supply for currencies. For example, a country with higher interest rates draws more foreign investors who are seeking greater returns. This results in the increase of demand for that currency. Other economic factors that affect demand and supply include inflation and the political and economic environment. Generally, the less stable the economy of a particular country is, the lower the demand for the currency is. In this instance, it is usually more expensive to purchase the currency because of the low supply as the transaction costs to purchase the currency are higher.
Ask and Bid Quote

One way to determine the demand and supply for a particular currency is to look at the spread between the ask and the bid price. Generally, a currency that is in high demand will have a smaller spread between the ask and big price than currencies with low demand. As an example, the spread for USD/JPY and EUR/USD is fairly small and is measured in fractions of a percent – these currencies have a high liquidity. This allows currency traders to easily get into and out of trades. On the other hand, currencies that have low liquidity usually have a low demand and high supply. These currencies will have larger spreads between the ask and bid prices.