Four ways to determine the rate of foreign exchange are:
(a) Demand for foreign exchange (currency) (b) Supply of foreign exchange (c) Determination of exchange rate (d) Change in Exchange Rate!
In a system of flexible exchange rate, the exchange rate of a currency (like price of a good) is freely determined by forces of market demand and supply of foreign exchange.
Expressed graphically the Intersection of demand and the supply curves determines the equilibrium exchange rate and equilibrium quantity of foreign currency. This is called equilibrium in foreign exchange market).
Let us assume that there are two countries—India and USA—and the exchange rate of their currencies, viz., rupee and dollar are to be determined. Presently there is floating or flexible exchange regime in both India and USA. Therefore, the value of currency of each country in terms of the other currency depends upon the demand for and supply of their currencies.
(a) Demand for foreign exchange (currency):
Demand for foreign exchange is caused (i) to purchase abroad goods and services by domestic residents, (ii) to purchase assets abroad, (iii) to send gifts abroad, (iv) to invest directly in shops, factories abroad, (v) to undertake foreign tours, (vi) to make payment of international trade, etc. The demand for dollars varies inversely with rupee price of dollar, i.e., higher the price, the lower is the demand. The demand curve in Fig. 10.1 is downward sloping because there is inverse relationship between foreign exchange rate and its demand.
(b) Supply of foreign exchange:
Supply of foreign exchange conies
(i) when foreigners purchase home country’s (say, India’s) goods and services through our exports
(ii) when foreigners make direct investment in bonds and equity shares of home country
(iii) when speculation causes inflow of foreign exchange
(iv) when foreign tourists come to home country
The supply curve is upward sloping (vide Fig. 10.1) because there is direct relationship between foreign exchange rate and its supply.
(c) Determination of exchange rate:
This is determined at a point where demand for and supply of foreign exchange are equal. Graphically, intersection of demand and supply curves determines the equilibrium exchange rate of foreign currency. At any particular time, the rate of foreign exchange must be such at which quantity demanded of foreign currency is equal to quantity supplied of that currency. It is proved with the help of the following diagram. The price on the vertical axis is stated in terms of domestic currency (i.e., how many rupees for one US dollar).
The horizontal axis measures quantity demanded or supplied of foreign exchange (i.e., dollars). In this figure, demand curve is downward sloping which shows that less foreign exchange is demanded when exchange rate increases (i.e., inverse relationship). The reason is that rise in the price of foreign exchange (dollar) increases the rupee cost of foreign goods which makes them more expensive. The result is fall in imports and demand for foreign exchange.
The supply curve is upward sloping which implies that supply of foreign exchange increases as the exchange rate increases (i.e., direct relationship). Home country’s goods (here Indian goods) become cheaper to foreigners because rupee is depreciating in value.
As a result, demand for Indian goods increases. Thus, our exports should increase as the exchange rate increases. This will bring greater supply of foreign exchange. Hence, the supply of foreign exchange increases as the exchange rate increases which proves the slope of supply curve.
In the Fig. 10.1, demand curve and supply curve of dollars intersect each other at point E which implies that at exchange rate of OR (QE), quantity demanded and supplied are equal (both being equal to OQ). Hence, equilibrium exchange rate is OR and equilibrium quantity is OQ.
(d) Change in Exchange Rate:
Suppose, exchange rate is 1 dollar = Rs 50. An increase in India’s demand for US dollars, supply remaining the same, will cause the demand curve DD shift to D’D’. The resulting intersection will be at a higher exchange rate, i.e., exchange rate (price of dollar in terms of rupees) will rise from OR to OR, (say, 1 dollar = 52 rupees). It shows depreciation of Indian currency (rupees) because more rupees (say, 52 instead of 50) are required to buy 1 US dollar. Thus, depreciation of currency means a fall in the price of home currency.
Likewise, an increase in supply of US dollar will cause supply curve SS shift to S’S’ and as a result exchange rate will fall from OR to OR2. It indicates appreciation of Indian currency (rupees) because cost of US dollar in terms of rupees has now fallen, say, 1 dollar = Rs 48, i.e., less rupees are required to buy 1 US dollar or now Rs 48 instead of Rs 50 can buy 1 dollar. Thus, appreciation of currency means ‘a rise in the price of home currency’.