How Foreign Exchange Rate is Determined?
The flexible exchange rate is determined by the forces of demand and supply of foreign exchange in the market. Under this, the equilibrium is established at a point where the quantity demanded is equal to the quantity supplied of foreign exchange, i.e., Demand for foreign exchange is similar to the supply of foreign exchange. This can be shown in Fig 1.
Observations:
It is evident in the diagram (Fig 1) that the rate of foreign exchange is shown on the Y axis, and the demand and supply of foreign exchange are shown on the X axis.
- DD is a negatively sloped Demand curve, and SS is a positively sloped Supply curve of foreign exchange that intersects each other at point E.
- Point E shows the equilibrium between the demand and supply of foreign exchange.
- Point E corresponds to the OR, which is the equilibrium rate of exchange and OQ, which is the quantity of foreign exchange demanded and supplied.
But now the question arises what if the exchange rate is not the Equilibrium exchange rate?
Case I: At the exchange rate higher than the equilibrium exchange rate, say OR2, there will be excess supply, i.e., Q1Q2. This is so because there is a positive relationship between the price of foreign exchange and the quantity supplied. Thus if the exchange rate rises, the quantity supplied also increases. On the other hand, demand will fall to OQ2, as there is a negative relationship between the price of foreign exchange and the quantity demanded. Thus the excess supply with the fall in demand for foreign exchange will push down the rate of foreign exchange (this indicates that the Indian Rupee will appreciate). It will again lead to an increase in demand from OQ2 to OQ, and a decrease in supply from OQ1 to OQ till it reaches equilibrium E.
Case II: Conversely, at the exchange rate lower than the equilibrium exchange rate says OR1, there will be excess demand, i.e., Q1Q2. This is so because there is a negative relationship between the price of foreign exchange and the quantity demanded. Thus if the exchange rate falls, the quantity demanded increases. On the other hand, supply will fall to OQ2, as there is a positive relationship between the price of foreign exchange and the quantity supplied. Thus the excess demand with an increase in the demand for foreign exchange will push up the rate of foreign exchange (this indicates that the Indian Rupee will depreciate). It will again lead to a decrease in demand from OQ1 to OQ and an increase in supply from OQ2 to OQ till it reaches equilibrium E.
Contact Us