Demand and Supply for Foreign Exchange

The foreign exchange rate is determined in the free foreign exchange  markets by the forces of ‘demand and supply for foreign exchange’. To make  the demand and supply functions to foreign exchange, like the conventional  market demand and supply functions, we define the rate of exchange as the price  of one unit of the foreign currency expressed in terms of the units of the home  currency.

The Demand for Foreign Exchange

Generally, the demand for foreign currency arises from the traders who  have to make payments for imported goods. If a person wants to invest his  capital in foreign countries, he requires the currency of that country. The  functional relationship between the quantity of foreign exchange demanded and  the rate of foreign exchange is expressed in the demand schedule for foreign  exchange (which shows the different rates of foreign exchange). It is  understood from the demand schedule that the relationship, between the  quantities of the foreign exchange demanded that the rate of foreign exchange is  inverse in such a way that a fall in the rates of exchange is followed and inverse  in the quantity of the foreign exchange demanded. The main reason for this  relationship is that, a higher rate of foreign exchange by rendering imports more  expensive reduces the demand for them and consequently, also reduces the  amount demanded of foreign exchange which is required to pay for imports. On  the other hand, a lower rate of exchange by making the imports cheaper causes  the demand for them to rise and consequently increases the demand for foreign  exchange needed to pay for higher imports.

Let us assume, that the rate of foreign exchange  is R1 and amount of foreign exchanges    demanded is Q1. When the rate of foreign exchange falls from R1  to R2, the amount of foreign exchange  demanded increases from Q1 to Q2. The amount demanded of the foreign exchange will  decrease when the rate of foreign exchange  rise i.e., when the foreign currency  becomes costlier in terms of domestic currency.

The demand of foreign exchange

The demand curve for the foreign exchange is shown in where the rate of  foreign exchange and the quantity of foreign exchange demanded have been  shown on the Y axis and X axis respectively. According to the demand curve  DD, which is negatively sloping from left to right, it can be seen that the foreign  exchange rate elasticity of demand for foreign exchange is less than infinity and  greater than zero. The demand for foreign exchange arising from the imports of  commodities and services, has the same foreign exchange rate elasticity, as is  the elasticity of demand for imported goods and services with respect to their  prices expressed in the local currency.

The Supply of Foreign Exchange

The need for and supply of foreign currency arises from the exporters  who have exported goods and services to foreign countries. The supply schedule  or curve of foreign exchange shows the different quantities of foreign exchange,  which would be available at different rate of foreign exchange, in the foreign  exchange market. The sources of supply of foreign exchange depend largely  upon the decisions of foreigners. The total quantity of the different goods and  services, which a country can export and, therefore, the quantity of foreign  currencies which it can acquire depends upon how many the residents of the  foreign currencies are willing to import from a particular country.

The Equilibrium Rate of Foreign Exchange

After deriving the demand and supply curves relating to foreign  exchange, the equilibrium rate of foreign exchange in the foreign exchange  market is determined through the point of intersection between the supply and  demand curves of foreign exchange. The rate  of exchange refers to the rate at which the currency of one country can be  converted into the currency of another country. Thus, it indicates the exchange  ratio between the currencies of two countries.

Demand and Supply of Foreign Exchange

In this figure the demand for and supply of foreign exchange have  been measured along the axis OX, and the rate of exchange along that of OY.  Whereas DD curve indicates the demand for a foreign currency. SS curve  indicates its supply. Both intersect at P demand and supply being equally  represented by OL, the rate of exchange is OR.  When supply of foreign exchange rises to OM, its demand remaining  constant, the rate of exchange declines to OR and when the demand for foreign  exchange rises to OM, its supply remaining constant, the rate goes up to OR.

Thus, we conclude that if the demand for a foreign currency increases, its  rate of exchange must go up, and if its supply exceeds its demand, the rate must  decline.

Credit:  International Business Finance-CU

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