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

In a system of flexible exchange rate, the exchange rate of a currency (like price of a commodity) is freely determined by forces of demand and supply of foreign exchange in the foreign exchange market. 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 is 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 as explained below.

(a) Demand for foreign exchange. 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 purchase foreign currency in anticipation of earnings profit (speculation), (vi) to undertake foreign tour, etc. The demand curve is downward sloping due to inverse relationship between foreign exchange rate and its demand vide Fig.(a).

(b)    Supply of foreign exchange. Supply of foreign exchange comes :
(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 cause inflow of foreign exchange, (iv) when foreign tourists come to home country, etc. The supply curve is upward sloping due to direct relationship between foreign exchange rate and its supply vide Fig.(a)

(c)    Determination of exchange rate. The equilibrium exchange rate is determined at a point where demand for and supply of foreign exchange are equal. Graphically intersection of demand and supply curves determine the equilibrium exchange rate of foreign currency. At any particular time, the price at which demand for foreign currency (say, dollar) equals its supply is called equilibrium rate of exchange. It is proved with the help of 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. The reason is that rise in the price of foreign exchange (dollar) increases the rupee cost of foreign goods which make 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. 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 Fig.(a) demand curve and supply curve of dollar 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. An increase in India's demand for US dollars, supply remaining the same will cause the demand curve DD to 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 OR₁ (Say from $1 = र 50 to $1 = र 52). It shows depreciation of Indian currency (rupees) because more rupees (र 52 instead of र 50) are required to buy one US dollar. Thus depreciation of a currency means ‘a fall in the price of home currency’. Likewise an increase in supply of US dollar will cause supply curve SS to shift to S'S' and as a result exchange rate will fall from OR to OR₂ (Say from $1 = र 50 to $1 = र 48). It indicates appreciation of Indian currency (rupees) because cost of US dollar in terms of rupee has now fallen, i.e., less rupees (र 48 instead of र 50) are required to buy one US dollar or a dollar fetches more rupees. Thus appreciation of currency means a rise in the price of home currency’.

Note: II may be noted that American dollars. British pounds, French francs and Japanese yen are considered Strong or Hard currencies as worldwide people have faith in their general acceptance as money. Indian Rupees and currencies of developing countries are considered Soft currencies since their exchange value is weak.

Fig. (a)

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