Exchange rates are prices that coordinate international transactions. When the market exchange rate is not at equilibrium, the resulting surplus or shortage creates pressure for the currency to adjust until quantity demanded equals quantity supplied.

Disequilibrium in the foreign exchange market

A foreign exchange (FX) market is a market for exchanging one currency for another. Like any market, it can be above, below, or at equilibrium.

This foreign exchange market diagram shows the demand and supply for a currency and the equilibrium exchange rate at the intersection. The higher exchange rate level (moving from $E_e$ to $E_1$) illustrates how the currency’s value can rise when market conditions shift so that the equilibrium occurs at a higher price. Source

An exchange rate is in equilibrium when:

This figure models the foreign exchange market with a downward-sloping demand curve and an upward-sloping supply curve for a currency. The intersection point marks the equilibrium exchange rate where the quantity demanded equals the quantity supplied, matching the condition $Q_D = Q_S$. Source

• the quantity of the currency demanded equals the quantity supplied

• there is no persistent tendency for the exchange rate to rise or fall

A disequilibrium exchange rate occurs when the current exchange rate is set:

• above the equilibrium rate (too high)

• below the equilibrium rate (too low)

Surplus vs shortage: what they mean in FX

In FX graphs, the “good” being bought and sold is the currency itself. Disequilibrium therefore creates a surplus or shortage of that currency.

A currency surplus (excess supply) happens when:

• the exchange rate is above equilibrium

• at that higher price, supply increases and demand decreases

• result: $Q_S > Q_D$ for the currency

A currency shortage (excess demand) happens when:

• the exchange rate is below equilibrium

• at that lower price, demand increases and supply decreases

• result: $Q_D > Q_S$ for the currency

Market adjustment back toward equilibrium

If there is a surplus of the currency (exchange rate too high)

When the currency is “overpriced” relative to equilibrium:

• sellers of the currency compete to exchange it

• to attract buyers, they accept a lower exchange rate

• the exchange rate falls until the surplus is eliminated

This adjustment is described as:

• depreciation of the currency (it buys fewer units of the other currency)

Key chain of reasoning:

• exchange rate above equilibrium → surplus of currency

• surplus puts downward pressure on the exchange rate

• exchange rate decreases → quantity demanded rises and quantity supplied falls

• market returns to equilibrium where $Q_D = Q_S$

If there is a shortage of the currency (exchange rate too low)

When the currency is “underpriced” relative to equilibrium:

• buyers compete to obtain the currency

• competition bids the price up, raising the exchange rate

• the exchange rate rises until the shortage is eliminated

This adjustment is described as:

• appreciation of the currency (it buys more units of the other currency)

Key chain of reasoning:

• exchange rate below equilibrium → shortage of currency

• shortage puts upward pressure on the exchange rate

• exchange rate increases → quantity demanded falls and quantity supplied rises

• market returns to equilibrium where $Q_D = Q_S$

How to describe adjustment clearly on an AP-style graph

To communicate the adjustment mechanism precisely, connect each step to the FX market:

• Identify whether the exchange rate is above or below equilibrium.

• State whether there is a surplus ($Q_S > Q_D$) or shortage ($Q_D > Q_S$) of the currency.

• Describe the pressure on the exchange rate:

  • surplus → exchange rate falls (depreciation)

  • shortage → exchange rate rises (appreciation)

• Explain that the exchange rate changes until the surplus/shortage is removed and the market is back at equilibrium.

Why the exchange rate moves (intuition)

The adjustment is driven by incentives:

• In a surplus, currency holders want to exchange more currency than others want to buy; they must accept a lower price.

• In a shortage, many agents want the currency but few are selling it; buyers offer a higher price.

This is the syllabus idea: disequilibrium exchange rates create surpluses or shortages, and market forces move the exchange rate back toward equilibrium.