The market or a platform in which the national currencies of various countries are exchanged or converted for each other is called the foreign exchange market. This market covers various institutions such as banks, official government agencies, dealers in foreign exchange etc.
The foreign exchange market is bifurcated-Spot market and Forward market.
A spot market handles spot or current transactions in foreign exchange. The exchange rate is Spot rate. The transactions are affected by the prevailing rates at the point of time and delivery of foreign exchange is thus affected.
A market where the foreign exchange is bought and sold for future delivery is called forward market. It deals with foreign exchange transactions that are contracted today but are implemented in future. The exchange rate prevailing in this market is Forward rate.
REASONS FOR RISING DEMAND FOR FOREIGN EXCHANGE
- In a situation of fall in foreign exchange rates, the imports from that foreign country becomes cheaper and thus, there will demand for higher imports. Hence the demand for that foreign currency increases.
- The price fall in foreign exchange rate also implies foreign currency becomes cheaper than domestic currency and promotes tourism to that country. This increases demand for foreign currencies.
The situation is just opposite for falling demand for foreign currencies where imports become costly and thus its demand falls.
REASONS FOR RISING SUPPLY OF FOR FOREIGN EXCHANGE
- In a situation of rise in foreign exchange rates, then the home country’s goods are cheaper to the foreign countries and thus, it increases the flow of foreign currency into home country by way of exports.
- A rise in foreign exchange rates also attract foreigners to visit home country as the home country’s currency becomes cheaper. This also increases supply of foreign currencies.
The situation is just opposite for falling supply of foreign exchange as investment in goods and services become costly for foreigners.
DETERMINATION OF FOREIGN EXCHANGE RATE
The exchange rate is determined at that point where demand for foreign exchange equates supply of foreign exchange which is nothing but the equilibrium exchange rate of foreign currency.
In the diagram above, there are two currencies US dollars(foreign country) and Indian rupees (home country) taken in X- axis and Y-axis respectively.
In the diagram, the demand curve is downward sloping. The reason of demand curve being negatively sloped, any graph for that matter, is because in general demand for a commodity increases when there is a decrease in its price. Thus, demand and price of that commodity are inversely related to each other. However, supply curve is positively sloped because supply and price have a direct relationship. In the context of foreign exchange market, demand (DD) is negatively sloped which implies less foreign exchange is demanded when exchange rate rises. Supply (SS) is upward sloping which mans that supply of foreign exchange rises with increase in exchange rate.
In the diagram , both curves intersect at point E which is the equilibrium point. OR is the equilibrium rate and the equilibrium quantity is OQ.
There are changes in the exchange rate only when there are changes in demand and supply. Suppose, if there is an increase in the demand for US dollars in India, it shifts the demand curve from DD to D’D’. The demand will increase the exchange rate shifting it from OR to OR1. It represents depreciation of Indian currency in terms of US dollars.
Similarly, a rise in the supply of US dollars will cause supply curve to shift from SS to S’S’ and the exchange rate would also shift from OR to OR2. This leads to appreciation of Indian rupees in terms of US dollars.
This is the process by which the exchange rate between various currencies take place.
Relevant links:https://www.ndtv.com/business/rupee-vs-dollar-rate-today-rupee-depreciates-to-74-23-against-dollar-amid-muted-domestic-equities-2475230 https://in.news.yahoo.com/goal-without-proper-plan-destined-074454320.html