Changes in Exchange Rate

The foreign exchange rate may rise or fall depending upon the changes in demand and supply of foreign exchange. 

1. Change in Demand

Change in Demand may be either an “Increase in Demand” or a “Decrease in Demand“

Change in demand is demonstrated in Fig 2. On the Y axis, the Rate of the exchange is shown and on the X axis, the Demand and Supply of foreign exchange are shown. DD is the demand curve and SS supply curve. Both curves (demand and supply) intersect each other at point E. Thus, E is the Equilibrium point. Equilibrium E corresponds to the OR Rate of foreign exchange rate and OQ quantity demanded.

Increase in Demand: 

The increase in the demand for foreign exchange will shift the demand curve from DD to D₁D₁. It can be seen in Fig 2 that due to a shift in the demand curve, the supply curve will now meet the demand curve at E₁, which will be the new Equilibrium point. Now, at the new equilibrium point, the exchange rate will increase to OR₁ with quantity demanded as OQ_1. It means that with an increase in demand, the exchange rate will also increase.  

Decrease in Demand: 

The decrease in the demand for foreign exchange will shift the demand curve from DD TO D₂D₂. It can be seen in Fig 2 that due to a shift in the demand curve, the supply curve will now meet the demand curve at E₂, which will be the new Equilibrium point. Now, at the new equilibrium point, the exchange rate will decrease to OR₂ with quantity demanded as OQ_2. It means that with a decrease in demand, the exchange rate will also decrease. 

2. Change in Supply

Change in Supply may be either an “Increase in Supply” or a “Decrease in Supply“.

Change in supply is demonstrated in Fig 3. On the Y axis, the Rate of exchange is shown and on the X axis, the Demand and Supply of foreign exchange are shown. DD is the demand curve and SS supply curve. Both curves (demand and supply) intersect each other at point E. Thus E is the Equilibrium point. Equilibrium E corresponds to the OR Rate of foreign exchange rate and OQ quantity supplied.

1. Increase in Supply:

The increase in the supply of foreign exchange will shift the supply curve from SS to S₁S₁. It can be seen in Fig 3 that due to a shift in the supply curve, the demand curve will now meet the supply curve at E₁, which is the new Equilibrium point. Now, at the new equilibrium point, the exchange rate will decrease to OR₁ with quantity demanded as OQ_1.. It means that with an increase in supply, the exchange rate will decrease. 

2. Decrease in Supply: 

The decrease in the supply of foreign exchange will shift the supply curve from SS to S₂S₂. It can be seen in Fig 3 that due to a shift in the supply curve, the demand curve will now meet the supply curve at E₂, which is the new Equilibrium point. Now, at the new equilibrium point, the exchange rate will increase to OR₂ with quantity demanded as OQ_2. It means that with a decrease in supply, the exchange rate will increase.