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.
(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.
(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.
Test
Yogita Ingle 5 years, 2 months ago
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.
(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.
(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.
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