What Are the Sources of Dollar Supply in Foreign Exchange?

The foreign-currency exchange market, or FX market, is a global marketplace where national currencies are traded. This market determines the exchange rates for currencies worldwide. The “supply of dollars” refers to the amount of U.S. dollars being offered for sale in exchange for other currencies. In an open economy, various international transactions require the conversion of dollars into foreign currencies, which generates this supply.

The Foreign Exchange Market Fundamentals

The foreign exchange market functions as a global platform for exchanging one national currency for another. It is the largest financial market globally, facilitating international trade, investment, and tourism. When the dollar is “supplied” in this market, it means that individuals, businesses, or governments holding U.S. dollars are offering them for sale to acquire a different currency. This exchange is fundamental for conducting transactions across borders. The supply of a currency in the FX market is driven by its holders’ need or desire to obtain other currencies to complete various international economic activities. This continuous need for currency conversion underpins the constant activity in the foreign exchange market.

Current Account Transactions Driving Dollar Supply

Transactions recorded under a country’s current account are a significant source of dollar supply in the foreign exchange market. The current account measures the flow of goods, services, and income between a country and the rest of the world. It includes the trade balance, primary income balance, and secondary income balance.

When US residents, businesses, or the government purchase foreign goods and services, they typically need to convert dollars into the currency of the exporting country. For example, an American company importing cars from Japan must exchange U.S. dollars for Japanese yen to pay the supplier. Similarly, a tourist from the United States traveling to Europe will convert dollars to euros to cover their expenses, thus supplying dollars to the market.

Income payments made by US entities to foreign individuals or businesses for the use of factors of production also contribute to dollar supply. This category includes interest paid on US bonds held by foreign investors, dividends distributed by US companies to their foreign shareholders, and wages or salaries paid to foreign workers in the US who send their earnings back to their home countries.

Unilateral transfers, specifically outflows from the US, represent another component of the current account that supplies dollars. These are transfers made without receiving a direct economic value in return. Examples include remittances sent by US residents to family members abroad or foreign aid payments provided by the US government to other nations.

Capital Account Transactions Driving Dollar Supply

Capital account transactions represent another substantial source of dollar supply. This account records international capital transfers and changes in ownership of financial assets. These financial flows are distinct from the trade in goods and services.

Outward Foreign Direct Investment (FDI) by US companies contributes significantly to dollar supply. When a US corporation establishes a new subsidiary, acquires an existing business, or expands operations in a foreign country, it must convert dollars into the local currency to finance these ventures. For instance, building a factory in Mexico or purchasing a company in Germany requires the conversion of substantial dollar amounts, making those dollars available in the foreign exchange market.

Similarly, outward portfolio investment by US investors generates dollar supply. This occurs when US individuals or institutions purchase foreign stocks, bonds, or other financial assets. An American investor buying shares in a European tech company or investing in Japanese government bonds will need to exchange dollars for the respective foreign currencies.

Another aspect of capital account transactions that drives dollar supply is when foreigners sell their holdings of US assets. If foreign investors sell US stocks, bonds, real estate, or other US-based assets, they receive payment in dollars. Should these foreign investors then wish to repatriate these funds to their home countries, they must convert the dollars into their domestic currency.

Additional Factors Influencing Dollar Supply

Beyond the regular flows of trade and investment, other specific actions can directly influence the supply of dollars in the foreign exchange market. These factors often involve strategic interventions or speculative activities by major market participants.

Central bank foreign exchange intervention is one such direct action. A country’s central bank, such as the Federal Reserve, can actively sell dollars and buy foreign currencies in the open market. This is typically done to influence the exchange rate, for example, to prevent the dollar from appreciating too rapidly or to manage foreign exchange reserves.

Speculative selling by large financial institutions and sophisticated market participants also adds to dollar supply. Hedge funds, investment banks, and other professional traders may sell significant quantities of dollars based on their expectations of future currency movements. For instance, if they anticipate a depreciation of the dollar, they might sell dollars now to buy them back later at a lower price, thereby supplying dollars to the market in the present.