Changes in investment flows
In Figure 10.5, the original equilibrium exchange rate is £1 = $2. If there is an increase in
the level of investment in the UK from overseas, there will be an increase in the demand
for pounds. The demand curve moves to the right (to D'D') and the exchange rate rises
to £1 = $2.5.
The effect of speculation
If the exchange rate of sterling is expected to rise, speculators will buy sterling in order
to make a capital gain by selling the currency later at a higher exchange rate. There will
be an increase in the demand for pounds and the exchange rate will rise. If the exchange
rate is expected to fall, speculators will sell sterling in order to avoid a capital loss, and
there will be an increase in the supply of sterling and therefore a fall in the exchange rate.
Illustrate these changes yourself using demand and supply diagrams.
The important thing about speculation is that it tends to be self-fulfilling. If enough
people believe that the exchange rate is going to rise and act accordingly, the exchange
rate will rise.