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 (e.g., the Naira) when demand for foreign exchange (e.g., US dollars) is greater than its supply.

Step 2: Explain the concept In a floating (market-determined) exchange rate system, the price of a currency is set by demand and supply, just like any other commodity.

• Foreign exchange is demanded when people need to import goods, pay school fees abroad, travel, etc.
• When more people want dollars than are available (demand > supply), the dollar becomes scarce, so its price rises.
• A higher price of the dollar in Naira terms means each Naira buys fewer dollars. For example, the rate moves from ₦800/$1 to ₦1,000/$1.

Step 3: Work through the solution

1. Demand for foreign exchange > supply of foreign exchange
2. Foreign currency becomes scarce, so its price rises
3. More Naira is needed to buy $1
4. The Naira buys less foreign currency, so its value falls

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

Step 4: Check the options

• A. Appreciates: wrong. This happens when supply of foreign exchange exceeds demand.
• B. Depreciates: correct.
• C. Remains unchanged: wrong. The imbalance moves the exchange rate.
• D. Expands: not a term used for currency value.

Tip: Think of foreign exchange as a commodity. When demand for dollars goes up, the dollar becomes more expensive and the Naira becomes weaker. Remember: Demand for foreign currency up → domestic currency down.