Rate of exchange is the price of one currency in terms of another currency. Therefore, like other prices, the rate of exchange is also determined in accordance with the general theory of value, i.e., by the interaction of the forces of demand and supply.
In other words, the exchange rate in a free exchange market is determined at a level where demand for foreign exchange is equal to the supply of foreign exchange.
1. Supply of Foreign Exchange:
The supply of foreign exchange comes from (a) the domestic exporters who receive payments of foreign currency; (b) the foreigners who invest and lend in the home country; (c) domestic residents who repatriate capital funds previously sent abroad; (d) the domestic residents who receive gifts from abroad.
The supply schedule for foreign exchange represents a functional relationship between different rates of exchange and the corresponding amounts of foreign exchange supplied. The supply schedule slopes upward to the right, indicating that at higher exchange rates larger amounts of foreign exchange are offered for sale.
2. Demand for Foreign Exchange:
Foreign exchange is demanded (a) by the domestic residents to import goods and services from abroad; (b) by the domestic residents investing and lending abroad; (c) by the foreign residents to repatriate funds previously invested in the home country; (d) for sending gifts to foreign countries.
The demand schedule for foreign exchange shows a functional relationship between different rates of exchange and the corresponding amounts of foreign exchange demanded.
The demand schedule slopes downward to the right, indicating that greater amounts of foreign currency are demanded at lower rates of exchange.