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Foreign Exchange Rate

The document explains the concept of exchange rates, which determine the value of one currency in terms of another, and introduces the equilibrium exchange rate where demand equals supply in the foreign exchange market. It outlines various factors influencing the demand and supply of foreign currency, including imports, investments, and government actions. The determination of the equilibrium exchange rate is described as a balance between demand and supply forces, affecting currency stability.

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5 views

Foreign Exchange Rate

The document explains the concept of exchange rates, which determine the value of one currency in terms of another, and introduces the equilibrium exchange rate where demand equals supply in the foreign exchange market. It outlines various factors influencing the demand and supply of foreign currency, including imports, investments, and government actions. The determination of the equilibrium exchange rate is described as a balance between demand and supply forces, affecting currency stability.

Uploaded by

MIHIR YT
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Foreign Exchange Rate

Introduction to Exchange Rates

❑ International trade involves the exchange of goods and services between


countries, which requires the conversion of one currency into another. This
necessity brings us to the concept of exchange rates, which determine the value
of one currency in terms of another.
❑ Definition of Exchange Rate
The exchange rate is the price of a country’s currency in terms of another
currency or a group of currencies. It reflects the purchasing power of a nation’s
currency in international markets and plays a crucial role in global economic
interactions.
Equilibrium Exchange Rate

❑ The equilibrium exchange rate is the exchange rate at which the demand for a
foreign currency equals its supply in the foreign exchange market. At this rate, there
is no excess demand or surplus supply, and the market remains stable.
❑ The idea of equilibrium exchange rate is similar to the concept of equilibrium price
in a commodity market. Just as the price of a commodity is determined by the
interaction of its demand and supply, the value of a foreign currency (in terms of
the domestic currency) is determined by:
▪ The demand for foreign currency in the domestic market
▪ The supply of foreign currency entering the country
Demand for Foreign Currency

❑ Definition
The demand for foreign currency refers to the need for a country’s residents,
businesses, and government to acquire foreign currency for various economic
activities. This demand arises because international transactions require
payments in foreign currencies.
Factors Influencing Demand for Foreign
Currency

1. Imports of Goods
▪ Countries import goods that are not produced domestically or are
cheaper/more advanced abroad.
▪ To pay for these imports, businesses and individuals need foreign currency.
▪ Example: India imports crude oil from the U.S. and the Middle East,
increasing demand for U.S. dollars.
2. Imports of Services
▪ Many countries import services such as tourism, banking, insurance,
transport, and education.
Factors Influencing Demand for Foreign
Currency

▪ With globalization, services trade has increased, raising the demand for
foreign currency.
▪ Example: Indian students studying in the U.S. pay tuition fees in dollars,
increasing demand for USD.
3. Unilateral Payments (Transfers to Foreign Countries)
▪ Foreign aid, remittances, and gifts sent to foreign residents create demand for
foreign currency.
▪ Example: If an Indian company donates money to a U.K.-based charity, it needs
to exchange INR for GBP.
Factors Influencing Demand for Foreign
Currency

4. Investment in Foreign Assets (Capital Outflows)


▪ When businesses or individuals invest in foreign stocks, bonds, or real estate,
they need foreign currency.
▪ Example: An Indian company investing in U.S. startups needs dollars, increasing
demand for USD.
5. Loan Repayments and Interest Payments
▪ Countries and corporations borrow from foreign sources and need to repay in
foreign currency.
▪ Example: If an Indian company took a loan from a U.S. bank, it needs dollars to
repay.
Factors Influencing Demand for Foreign
Currency

6. Speculation and Hedging


▪ Investors and traders buy foreign currencies if they expect the exchange rate to rise,
hoping to sell at a profit later.
▪ Example: A forex trader buys euros expecting the EUR to appreciate against INR.
7. Government Purchases and Foreign Reserves
▪ Central banks purchase foreign currency to stabilize exchange rates and maintain
reserves.
▪ Governments also buy foreign currencies for international trade agreements and
diplomatic expenses.
Supply of Foreign Currency

 Definition
▪ The supply of foreign currency refers to the amount of foreign exchange available
in a country’s economy. It comes from various sources, including exports, foreign
investments, and remittances. The supply of foreign currency increases when more
foreign exchange enters the country through these channels.
Supply of Foreign Currency

 Factors Influencing the Supply of Foreign Currency


1. Exports of Goods
▪ Countries earn foreign exchange when they sell goods to other nations.
▪ Example: India exports software and textiles to the U.S., receiving payments in
U.S. dollars, increasing the supply of USD in India.
2. Exports of Services
▪ Just like goods, services such as IT, consulting, tourism, and outsourcing bring
in foreign exchange.
▪ Example: Indian IT companies providing services to U.S. firms earn payments in
dollars, increasing the supply of USD in India.
Supply of Foreign Currency

3. Unilateral Receipts (Remittances & Foreign Aid)


▪ Money received from foreign countries in the form of remittances, gifts, and aid
increases foreign exchange supply.
▪ Example: Indian workers in the UAE send money home in rupees, converting their
salaries from AED, increasing rupee supply.
4. Capital Inflows (Foreign Investments & Loans)
▪ Foreign Direct Investment (FDI): When foreign companies invest in a country’s
businesses, they bring foreign currency.
▪ Foreign Portfolio Investment (FPI): Foreign investors buying stocks and bonds
bring in foreign exchange.
Supply of Foreign Currency

▪ Loans & Borrowings: International loans taken by the government or companies


increase foreign currency reserves.
▪ Example: If Google invests in an Indian startup, it brings dollars, increasing USD
supply in India.
Supply of Foreign Currency

5. Speculation & Currency Trading


▪ Foreign exchange traders sell foreign currencies when they expect prices to fall,
increasing supply.
▪ Example: If traders expect the USD to depreciate, they sell dollars, increasing USD
supply in the market.
6. Government & Central Bank Actions
▪ Central banks influence foreign exchange supply by selling or buying currencies in
the forex market to stabilize exchange rates.
▪ Example: If the Reserve Bank of India (RBI) sells USD from its reserves, it
increases the supply of USD in the Indian market.
Determination of Equilibrium Exchange Rate
Determination of Equilibrium Exchange
Rate

❑ Definition
▪ The equilibrium exchange rate is the rate at which the demand for foreign
currency equals the supply of foreign currency in the foreign exchange market. At
this rate, there is no excess demand or surplus supply, keeping the currency value
stable.
Determination of Equilibrium Exchange
Rate

❑ How the Equilibrium Exchange Rate is Determined


▪ The equilibrium exchange rate is set by the interaction of demand and supply
forces in the foreign exchange market. This process follows the principles of a
free-market economy, where:
▪ If demand for foreign exchange exceeds supply, the currency depreciates.
▪ If supply of foreign exchange exceeds demand, the currency appreciates.
▪ When demand equals supply, the exchange rate stabilizes at the equilibrium
level.
Example of Exchange Rate Determination

▪ If the market exchange rate for INR/USD is ₹80 per USD, the following happens:
▪ If demand for USD rises, it creates a shortage, pushing the exchange rate higher
(e.g., ₹82/USD).
▪ If supply of USD rises, it creates a surplus, pushing the exchange rate lower (e.g.,
₹78/USD).
▪ When demand = supply, the exchange rate stabilizes, establishing equilibrium.

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