How Rate of Exchange is Determined in the Foreign Exchange M?

The rate of exchange being a price of a national currency in terms of another, is determined in the foreign exchange market in accordance with the general principle of the theory of value, i.e., by the interaction of the forces of demand and supply.

Thus, the rate of exchange in the foreign exchange market will be determined at the point at which the total amount of foreign money demanded as represented by the demand curve for foreign exchange is equal to total amount of supply made available as represented by the supply curve for foreign exchange.

The country’s import of goods and services, investment in foreign countries, i.e., an outward movement of capital, and other payments involved in international transactions which may cause an outflow of gold in the process of disbursement determine its demand for foreign exchange. On the other hand, the supply of foreign exchange {i.e., the availability of foreign currencies to the country concerned in its foreign exchange market) depends on the country’s export of goods and services to the foreign countries, investments of foreign countries in this country constituting an inward movement of foreign capital, and other receipts from the rest of the world which may envoy an inflow of gold too.

Moreover, though, the rate of exchange is the function of demand and supply of foreign exchange [to express symbolically: R = f(D,S)], it has an important bearing on the determination of demand and supply of foreign exchange. In fact, D = f (R) and S = f (R).

That is to say, the demand for foreign exchange depends on the exchange rates. When the term ‘exchange rate’ is interpreted as the external value (price) of home currency in terms of foreign currency (dollar price of rupee, for instance), the demand for foreign exchange is the direct function of the rate of exchange.

It varies directly as exchange rate. Likewise, the supply of foreign exchange also depends on the exchange rates. It is, however, an inverse function of the rate of exchange, implying that the supply of foreign exchange will contract at a high rate of exchange and expand at a low rate of exchange.

It will be noticed, thus, that in the above diagram the demand and supply curves are the exact opposites of the usual curves. Here the demand curve has a positive slope showing that the amount of foreign exchange demanded increases as the rate of exchange increases and vice versa. For, when the rate of exchange is high, the value of a unit of home currency in terms of foreign currency is high, so that, imports are encouraged and the demand for foreign currency will rise.

On the other hand, the supply curve has a negative slope showing that when the rate of exchange is low the supply of foreign exchange is large and vice versa. This is because a low exchange rate indicates a high value of foreign currency in terms of home currency so that, export will be encouraged, which will cause an increase in the supply of foreign currency.

Needless to say that, the demand and supply of foreign exchange are derived. The demand schedule is basically derived from imports and supply schedule of foreign exchange is derived from exports of the country concerned. Further, the demand and supply of foreign exchange are also composite in nature; as they are made up of the demand and supply of many different goods and services.

It is obvious that, if the rate of exchange is above or below the equilibrium point of interaction of demand and supply curves, conditions of excess demand or excess supply (ab and cd as shown in the diagram) would come to exist in the foreign exchange market.

The excess of demand for foreign currency will push up its price (in terms of home currency). Hence, the rate of exchange will fall, demand for it will contract and its supply will expand. The process will continue till both demand and supply become equal. Conversely, if there is excess of supply of foreign currency, the value of home currency and with it the rate of exchange would rise.