Determination of Exchange Rate in Free / Flexible Rate System:
- In a system of flexible exchange rate, the exchange rate of a currency is freely determined by the forces of demand and supply of foreign exchange in the foreign exchange market.
- Graphically the point of intersection of demand and supply curves determines the equilibrium quantity of foreign currency. This is called equilibrium in foreign exchange market.
- Let it assume that there are two countries India and USA and exchange rate of their currencies rupee and dollar is to be determined.
- In flexible or floating exchange rate system the value of currency of each country in terms to the other country’s currency depends on demand and supply of their currencies.
a. Demand for foreign Exchange:
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Sources of Demand of Foreign Exchange:
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To purchase goods and services from foreign
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To purchase financial assets (bonds and equity shares) in a foreign country
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To invest directly in shops, factories, building in foreign countries
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To send gifts and grants abroad
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To undertake foreign goods.
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The demand of foreign exchange have inverse relation with flexible exchange rate. If the exchange rate rises, the demand of foreign exchange falls and vise versa.
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Example, at higher exchange rate the quantity of goods imported from USA will be less because of higher price of imported goods. Therefore the amount of dollars demanded will be less.
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Similarly, at lower exchange rate the quantity of goods imported from USA will be higher because of low prices of imported goods. Therefore the amount of dollars demanded will be high.
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The demand curve DD is downward due to inverse relationship between foreign exchange rate and its demand.
b. Supply of Foreign Exchange:
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Sources of Supply of Foreign Exchange:
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Direct purchases by foreigners in domestic market
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Direct investment by foreigners (bonds and equity shares) in domestic market
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Remittance by non – residents living abroad.
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Speculation cause inflow of foreign exchange
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Export of goods and services.
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Foreign tourists coming to domestic country.
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There is a direct relationship between the rate of exchange and its supply.
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The higher the exchange rate, the higher is the supply of foreign exchange and vice versa.
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The supply curve (SS) of foreign exchange is normally positively sloping.
c. Determination of Exchange Rate:
Equilibrium Exchange Rate
Where, DD = Demand curve
SS = Supply curve
E0 = Equilibrium point
r0 = Equilibrium rate of exchange
Q = Equilibrium quantity demanded / supply of dollar
AB = Excess demand
GH = Excess supply
The equilibrium exchange rate is determined at a point where the quantity demanded and supplied of foreign exchange is equal.
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Demand curve DD shows how many dollars India demands at different rates of exchange, and the supply curve SS shows how the supply of dollars changes as the exchange rate varies.
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Graphically the point of intersection of DD curve and SS curve is point E0.
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At the exchange rate r0 the Indian demand for dollars equals the American supply of dollars, the foreign exchange market is cleared.
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If the price of dollar in terms of rupee is low i.e., r1. The demand for dollar exceeds the supply by AB amount. This will cause the price of dollar to rise. The value of dollar appreciate and rupee will depreciate.
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If the price of dollar in terms of rupee is higher i.e., r2. The supply of dollar exceeds the demand by GH amount. The excess supply of foreign exchange will cause the value of foreign currency to fall. This results in depreciation of dollar in terms of rupee or an appreciation of rupee.
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In the given graph – demand curve DD and supply curve SS of dollar intersect each other at E0.
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At E0 point the quantity demanded and supplied are equal. Hence equilibrium exchange rate is Or0 and equilibrium quantity is OQ.
d. Change in Exchange Rate:
Change in Equilibrium Exchange Rate
1. When there is a deficit in Balance of Payment:
When there is a deficit in BoP due to increase in import or investment abroad, there arise an excess demand of foreign currency.
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This leads to a rightward shift of demand curve (D1D1 curve ).
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This shift will increase the price of dollar in terms of rupees.
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As a result the quantity demanded of dollars falls and quantity supplied increases till the deficit is wiped out.
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As a result a new equilibrium is established and r1 is new exchange rate.
2. When there is a surplus of Balance of Payment:
When there is a surplus of BoP due to increase in export or foreign investment in domestic country (India).
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This causes an excess supply of foreign exchange and shifts the supply curve (SS) rightward (S1S1).
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The excess supply of dollar will lead to a fall in the exchange rate in terms of rupee i.e., appreciation of rupee.
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This will cause the import cheaper and export costlier.
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Hence import increase and export will fall till the surplus in BoP is wiped out.
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A new equilibrium in balance of payment is established at lower exchange rate.
Therefore a change in demand or supply in foreign exchange in the foreign exchange market will lead to a change in the exchange rate.
An increase in imports, investment abroad, inflation at-home and disturbed economic conditions at home increase the demand of foreign exchange,and this results in depreciation of country’s currency i.e., increase in exchange rate.
On the other side, increase in exports, increased foreign investments, availability of loans from abroad, increase in the bank rate within the country, peace and security in the country etc. will increase the supply of foreign exchange leading to appreciation in the home currency.
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