As from our previous example, we assume that there are 2 countries India and USA, and there is flexible exchange rate regime. Therefore value of currency of each country in terms of the other depends on the demand and supply of their currencies. It is in the foreign exchange market that exchange rate among different countries is determined. It is a market in which currencies of various countries are converted into each other or exchanged for each other. In our case, Indians sell rupees to buy US dollar and the Americans will sell dollars in exchange for rupees.
Demand for dollar
Now demand for dollar by Indians arises due to the following:
· The Indian individuals, firms or government who import goods from USA into India, as they need to pay for goods and services imported.
· The Indian individuals travelling and studying in USA would require to meet their travel expenses and education expenses.
· The Indians who want to invest in equity shares and bonds of the US companies and other financial instruments.
· The Indian firms who want to invest directly in building factories, sales facilities, shops in USA.
Supply of dollar
Let’s see what causes supply of dollars in exchange market:
· The individual firms and government which export Indian goods to USA will earn dollar from American residents who would buy Indian goods imported into USA and pay their price in dollar.
· Americans who travel to India and use the services of Indian transport, hotels etc .will also supply dollars to be converted into rupees for meeting these expenses.
· American firms and individuals who want to buy assests in India , such as bonds and equity shares of Indian companies or wish to make loans to Indian individual and firms will also supply dollars.
Equilibrium is establish in foreign exchange markets by simple demand and supply of currencies…..when
Demand= supply, then foreign exchange market is said to be in equilibrium. The equilibrium in the foreign exchange market will be disturbed if some changes occur in the underlying factors that determine the demand for and supply of foreign exchange.
Appreciation of rupee
For e.g., if there is in increase in incomes of American people due to boom conditions in the US economy, it will affect the equilibrium rate of exchange. The increase in incomes of the people of USA will lead to increase in demand for imported goods those of India. Now this would lead to increase in supply of dollars, which would in turn lower the price of dollars in the foreign exchange market by simple theory of demand and supply, as now there will be excess supply of dollars. This implies that increase in imports by USA from India leading to more exports from India will cause dollar to depreciate and Indian rupee to appreciate.
Depreciation of rupee
On the other hand if due to increase in incomes of Indian people causing arise in demand for American consumer goods or there is picking up of industrial activity in India requiring more imports of material, machines equipments and other capital goods from USA the Indian imports from USA will increase. The increase in imports from USA by India will have to be paid in dollars causing demand for dollars to increase. This will cause disequilibrium in the foreign exchange market, as with increase in demand for dollars, there will emerge excess demand for dollar which will push up the price of dollar and this rise in price of dollars in terms of rupees implies depreciation of value of rupee.
This how the foreign exchange market works……………..for more details you can refer to books like
· Dornbush R. and S. Fisher., Macroeconomics
· Mankiw, N.G., Macroeconomics
· Froyen R.T., Macroeconomics,