Economics · Ch 6 — Open Economy Macroeconomics
Foreign Exchange Rate
Foreign Exchange Rate
6.2.1 Foreign Exchange Rate
The foreign exchange rate — often called the forex rate — is simply the price of one currency expressed in terms of another. It is the mechanism that links the currencies of different countries and makes it possible to compare costs and prices across borders.
Suppose you need to pay ₹50 to get one US dollar. The exchange rate is then ₹50 per dollar. To keep things simple, the textbook assumes a two-country world consisting only of India and the United States. In such a world there is only one exchange rate that needs to be determined — the rupee-dollar rate.
Demand for Foreign Exchange
People demand foreign currency for three main reasons:
- They want to buy goods and services from other countries (imports).
- They want to send gifts or make transfers abroad.
- They want to purchase financial assets of a foreign country.
The relationship between the price of foreign exchange and the quantity demanded is straightforward. When the price of foreign exchange rises — meaning the rupee depreciates — the cost of buying a foreign good in terms of rupees goes up. A ₹50-per-dollar good becomes more expensive if the rate moves to ₹55 per dollar. This higher cost discourages imports, and therefore the demand for foreign exchange falls, other things remaining the same.
Do not confuse the price of foreign exchange with the price of imported goods. The exchange rate is the price of one currency in terms of another; it is not the price of the goods themselves. A rise in the exchange rate makes imports costlier, which then reduces the quantity of foreign exchange demanded.
Supply of Foreign Exchange
Foreign currency flows into the home country through three channels:
- Exports: when foreigners buy Indian goods and services, they pay in foreign currency (or its equivalent), which adds to the supply of foreign exchange in India.
- Gifts and transfers: foreigners send gifts or make transfers to residents of India.
- Capital inflows: foreigners purchase Indian assets — shares, bonds, real estate, or other financial assets.
The effect of a change in the exchange rate on supply is more complex than the effect on demand. When the price of foreign exchange rises — say from ₹50 to ₹55 per dollar — the cost for a foreigner buying Indian products falls in terms of dollars. A ₹500 Indian good that cost 9.09 at ₹55 per dollar. This makes Indian exports cheaper for foreigners, so exports tend to rise. As exports increase, the supply of foreign exchange into India also tends to increase. …