Foreign Exchange Rate
Foreign 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
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
❑ 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
▪ 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.