Demand and Supply View

of Exchange Rate

Dr.C S Shylajan
Faculty, 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 countrys point of view (for
example, Indias 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
2006)

: 45.3200 (In

INR / 1 USD
(2/11/2007)

: 39.3200

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 countrys 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