Q.(a) Explain and illustrate how the rate of Exchange is determined.

(a) Rate of exchange = the price of one currency in terms of another, fixed where demand for and supply of foreign exchange are equal. (b) SAARC = 8-nation South Asian regional-cooperation body (1985); BRICS = Brazil, Russia, India, China, South Africa — a bloc of major emerging economies.

(a) Determination of the Rate of Exchange (equilibrium/demand-supply theory)

The rate of exchange is the price of one country's currency in terms of another's. In a free (flexible) exchange market it is determined by the demand for and supply of foreign exchange:

• Demand for foreign exchange comes from imports of goods and services, foreign travel, and investment abroad. Like any demand curve, it slopes downward — a higher exchange rate (costlier foreign currency) reduces the quantity demanded.
• Supply of foreign exchange comes from exports, foreign tourists, and inflow of foreign investment. The supply curve slopes upward — a higher exchange rate makes it more attractive to supply foreign currency.

Diagram (described in words): The rate of exchange is measured on the vertical (Y) axis and the quantity of foreign exchange on the horizontal (X) axis. The downward-sloping demand curve (DD) and the upward-sloping supply curve (SS) intersect at a point E. This point of intersection determines the equilibrium rate of exchange (OR) and the equilibrium quantity of foreign exchange (OQ). If the rate is above equilibrium, supply exceeds demand and the rate falls; if below, demand exceeds supply and the rate rises — restoring equilibrium at E.

(b) Notes on SAARC and BRICS …