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Demand and Supply View of Exchange Rate
Dr.C S ShylajanFaculty, IBS Hyderabad
Topics
Exchange Rate Regimes
Foreign Exchange Market
The Basic Model of Determination of Foreign Exchange Rate
International transactions, foreign exchange rate and foreign exchange market
Inflow and outflow of money in a country
Results from economic interactions with the rest of the world
These interactions require one currency be exchanged for another currency
International transactions, foreign exchange rate and foreign exchange market
How do these exchanges occur?
What institutions are involved in the process?
How much domestic currency would be needed to obtain the desired amount of foreign currency?
Exchange Rate Foreign exchange rate is the price of
domestic currency in relation to another currency
INR / 1 USD : 48.60 INR / 1 Euro : 65.10 INR / 1 Pound Sterling : 73.22 Source: RBI (as of 13-01-09)
Exchange Rate
Foreign exchange rate is determined in the foreign exchange market
Exchange of domestic currency for foreign currency occurs in the foreign exchange market
Foreign Exchange Market
Individuals, businesses, and governments They obtain foreign currency to conduct
different types of transactions (both current and capital account)
How would such transactions occur? Usually, facilitated by commercial banks Currencies are traded at the retail level in
many banks and firms specializing in that business (List of Authorized Dealers in RBI website)
Foreign Exchange Market
Foreign exchange is a financial asset
These may be currencies, bank deposits i.e foreign-currency bank deposits
Commercial banks are the primary traders in the foreign exchange market
Central banks also frequently buy and sell foreign exchange to influence the value of their own currencies
How markets determine the price of foreign currencies?
DD and SS determines the rate in a flexible exchange rate regime
Usually view transaction from the domestic country’s point of view (for example, India’s side)
Exchange rate will be expressed as the number of units of domestic currency needed to obtain a unit of foreign currency
How markets determine the price of foreign currencies?
INR / 1 USD : 48.60
Appreciation Vs Depreciation
An Appreciation is an increase in the value of a currency. For instance Rupee gets strengthened.
Ex: In 2007, INR 37/1$
A Depreciation is a decrease in the value of a currency. Rupee gets weakened against dollar
Ex:In 2009, INR 48.60/1$
How markets determine the price of foreign currencies?
The foreign exchange settle at that price where supply and demand are in balance
For example, the equilibrium exchange rate occurs when the quantity demanded of a currency (INR) is equal to the quantity supplied of a currency (INR).
Demand Side
Demand for foreign currency is derived from the DD for foreign goods and services from Indian side
What factors affect this Demand? Suppose transaction between India
and US India imports Cars from US
Demand Side
INR / 1 USD : 45.3200 (In 2006)
INR / 1 USD : 39.3200 (2/11/2007)
When Rupee appreciated Indian import of US cars become less expensive
The quantity demanded increased for US cars
Hence more DD for US dollar
Shifts in the Demand for Foreign Exchange
What would cause the demand curve for foreign exchange to shift?
Change in domestic income Change in relative prices A country’s taste and preferences
Shifts in the Demand for Foreign Exchange
Change in Domestic Income Indian GDP goes up Personal disposable income goes up Demand for US products goes up Hence more import demand and
more demand for USD at the corresponding exchange rate
Shifts in the Demand for Foreign Exchange
Change in Relative Prices
Price of US goods decreases
We import more from US
Hence more demand for USD
Supply of Foreign Exchange
US demand for Indian products US importer who wished to buy
Indian products needs to obtain the Indian Rupees from bank by exchanging US dollar at current exchange rate.
This US demand creates a supply of US dollar
Equilibrium
DD and SS forces determines the equilibrium exchange rate
Change in Equilibrium exchange rate
If there is change in any factors which influence demand and supply
FX determination According to Flow Models, as the home currency
depreciates, imports become more expensive while exports become cheaper in terms of foreign currency
Demand for imports falls while for exports expands
Supply of foreign currency rises while demand shrinks, putting upward pressure on the home currency
FX determination
Suppose, demand for imports rises (due to faster economic growth at home, etc), other things remaining the same, the home currency will depreciate
Alternatively, exports shrink (due to supply problems in export industries, economic slow down in buyer country, competition, etc), home currency depreciate
Conversely, when demand for imports shrinks or that for exports rises, the home currency appreciate
FX determination Thus, in this approach the exchange
rate is influenced by the forces affecting demand and supply of imports and exports
These include fiscal and monetary policies that affect the level of economic activity, productivity changes, changes in consumer preferences, tariffs and trade barriers, etc