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The Supply and Demand Theory in Forex

Forex Supply and Demand

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.

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.