Final answer:
In a fixed exchange rate market, changes in demand for foreign currency require central bank intervention to maintain the fixed rate. Rising demand for a foreign currency usually leads to central bank actions to buy its own currency using reserves. Factors like interest rates, inflation, and speculation can all influence demand and supply in the foreign exchange market.
Step-by-step explanation:
In a fixed exchange rate market, when there is a change in demand for foreign currency, the central bank must take action to maintain the fixed rate. If demand for a foreign currency increases, it implies a weakening demand for the local currency. To counter this, the central bank will use its foreign exchange reserves to buy up its own currency, thus sustaining its value.
For instance, if investors believe the U.S. dollar will strengthen, there will be an increase in demand for dollars. The supply side may respond differently based on economic factors like interest rates and inflation. A scenario with high interest rates will tend to attract foreign investment, increasing demand for the local currency and possibly leading to a stronger currency. Oppositely, high inflation can lead to a weaker currency as it erodes the currency's purchasing power.
Speculation also plays a role in the foreign exchange market, where expectations about future exchange rates can lead to shifts in demand and supply, influencing the short-term exchange rate. For example, positive news about a currency's future value can increase its demand, leading to an appreciation, and vice versa for negative news.