When the demand for foreign exchange exceeds its supply, the value of the domestic currency

Step 1: Analyze the question The question asks what happens to the value of the domestic currency when demand for foreign exchange is greater than its supply.

Step 2: Explain the concept The exchange rate is the price of one currency in terms of another, and it is determined by demand and supply, just like the price of any good.

• Foreign exchange (e.g., US dollars) is demanded by Nigerians who want to import goods, pay school fees abroad, travel, or invest overseas.
• When people demand more dollars than are available, the price of the dollar rises. This means more naira is needed to buy one dollar.

Step 3: Work through it

1. Demand for foreign exchange > supply of foreign exchange
2. The foreign currency becomes scarce, so its price rises (e.g., from ₦800/$to ₦1,000/$)
3. More naira is needed to buy the same amount of dollars
4. So the naira is worth less in terms of foreign currency

A fall in the value of a currency under a floating exchange rate system is called depreciation. (If the government deliberately lowers the value under a fixed system, it is called devaluation.)

Step 4: Check the other options

• A. Appreciates: this happens when supply of foreign exchange exceeds demand.
• C. Expands: not a term used for currency value.
• D. Increases: the value falls, not rises.
• E. Inflates: inflation refers to a general rise in prices, not exchange rate movement.

Answer: B. depreciates

Tip: Remember "Demand for foreign money up, local money down." Excess demand for foreign exchange means the domestic currency depreciates. Excess supply of foreign exchange means the domestic currency appreciates.