How is the foreign exchange rate determined? Explain with the help of a diagram.

The exchange rate of a currency in a flexible exchange rate system is determined by the forces of the demand and supply of foreign exchange in the foreign exchange market. Graphically the intersection of the demand and supply curve will determine the equilibrium exchange rate and the equilibrium quantity of the foreign currency. This is called equilibrium in the foreign exchange market.

Assumptions:

a. There are two countries India and the USA.

b. The exchange rate between Rupee and Dollar has to be determined. c. Both countries follow a flexible exchange rate system.

Demand for foreign exchange:

a. To purchase goods and services abroad by domestic residents.

b. To purchase assets abroad.

c. To send gifts abroad.

d. To undertake a foreign tour.

e. To purchase foreign currency to earn higher profits.

f. To make any investment abroad.

Supply for foreign exchange:

a. When foreigners purchase goods and services from the home country through Exports.

b. When foreigners purchase assets in the home country.

c. When speculation leads to the inflow of foreign exchange.

d. When foreigners make an investment in the form of bonds and equity shares of the home country.

e. When foreigners undertake a tour in the home country.

Explanation:

a. The price on the vertical axis is stated in terms of the domestic currency.

b. The vertical axis represents the quantity demanded or supplied to foreign exchange.

c. The demand curve is downward sloping due to the inverse relationship between the foreign exchange rate and its demand.

d. The supply curve is upward sloping due to the direct relationship between the foreign exchange rate and its supply.

e. The downward-sloping demand curve indicates that less foreign exchange is demanded when the exchange rate increases. The rise in the price of the dollar increases the rupee cost of foreign good which makes it more expensive. It leads to a fall in the import and the demand for foreign exchange.

f. The upward-sloping supply curve indicates that the supply of foreign exchange increases with an increase in the exchange rate. Indian goods become cheaper in the US because the value of Rupee is depreciating. The demand for Indian goods increases which leads to an increase in the export. It increases the supply of foreign exchange.

g. Both the demand and supply curves intersect at point E. At the exchange rate of OR, the quantity supplied and demanded is equal.

h. The equilibrium exchange rate is OR and the equilibrium quantity is OQ.