Determination and Demand of Exchange Rates / Equilibrium Rate of Foreign Exchange

Determination of Exchange Rates / Equilibrium Rate of Foreign Exchange

The foreign exchange rate is determined in the free foreign exchange markets by the forces of ‘demand for and supply for foreign money’. To make the demand and supply functions to foreign exchange, like the conventional market demand and supply functions, we define the rate of exchange as the price of one unit of the foreign currency expressed in terms of the Units of the home currency.

The Demand for Foreign Exchange

Generally, the demand for foreign currency arises from the traders who have to make payments for imported goods. If a person wants to invest his capital in foreign countries, he requires the currency of that country. The functional relationship between the quantity of foreign exchange demanded and the rate of foreign exchange is expressed in the demand schedule for foreign exchange {which shows the different rates of foreign exchange}. It is understood from the demand schedule that the relationship, between the quantities of the foreign exchange demanded that the rate of foreign exchange is inverse in such a way that a fall in the rates of exchange is followed and inverse in the quantity of the foreign exchange demanded. The main reason for this relationship is that, a higher rate of foreign exchange by rendering imports more expensive reduces the demand for them and consequently, also reduces the amount demanded of foreign exchange which is required to pay for imports. On the other hand, a lower rate of exchange by making the imports cheaper causes the demand for them to rise and consequently increases the demand for foreign exchange needed to pay for higher imports.

Let us assume, that the rate of foreign exchange {price of US dollar expressed in terms of Indian rupees} is R1 and amount of foreign exchanges (US dollar) demanded is Q1. When the rate of foreign exchange falls from R1 to R2, i.e., the rupee price of the US dollar falls, the amount of foreign exchange demanded increases from Q1 to Q2. This happens because, consequent upon the US dollar becoming cheaper in terms of Indian rupees, the dollar price of the American goods remaining unchanged, the prices expressed in terms of Indian currency fall and consequently the demand for the American export foods in India increases, unless the extreme assumption is made that such demand is perfectly price inelastic. The amount demanded of the foreign exchange will decrease when the rate of foreign exchange rise i.e., when the foreign currency becomes costlier in terms of domestic currency.

The demand curve for the foreign exchange is shown in where the rate of foreign exchange and the quantity of foreign exchange demanded have been shown on the Y axis and X axis respectively. According to the demand curve DD, which is negatively sloping from left to right, it can be seen that the foreign exchange rate elasticity of demand for foreign exchange is less than infinity and greater than zero. The demand for foreign exchange arising from the imports of commodities and services, has the same foreign exchange rate elasticity, as is the elasticity of demand for imported goods and services with respect to their prices expressed in the local currency.

The Supply of Foreign Exchange

The need for and supply of foreign currency arises from the exporters who have exported goods and services to foreign countries. The supply schedule or curve of foreign exchange shows the different quantities of foreign exchange, which would be available at different rate of foreign exchange, in the foreign exchange market. The sources of supply of foreign exchange depend largely upon the decisions of foreigners. The total quantity of the different goods and services, which a country can export and, therefore, the quantity of foreign currencies which it can acquire depends upon how many the residents of the foreign currencies are willing to import from a particular country.

The Equilibrium Rate of Foeign Exchange

After deriving the demand and supply curves relating to foreign exchange, the equilibrium rate of foreign exchange in the foreign exchange market is determined through the point of intersection between the supply and demand curves of foreign exchange as shown in the following figure. The rate of exchange refers to the rate at which the currency of one country can be converted into the currency of another country. Thus, it indicates the exchange ratio between the currencies of two countries.

The demand for the supply of a foreign exchange, and how these affect the rate of exchange, in this figure the demand for and supply of foreign exchange have been measured along the axis OX, and the rate of exchange along that of OY. Whereas DD curve indicates the demand for a foreign currency. SS curve indicates its supply. Both intersect at P demand and supply being equally represented by OL, the rate of exchange is OR.

When supply of foreign exchange rises to OM, its demand remaining constant, the rate of exchange declines to OR and when the demand for foreign exchange rises to OM, its supply remaining constant, the rate goes up to OR.

Thus, we conclude that if the demand for a foreign currency increases, its rate of exchange must go up, and if its supply exceeds its demand, the rate must decline.