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