Friday, August 28, 2009
Equilibrium Rate of Exchange
The foreign exchange rate or exchange rate is the rate at which one currency is exchanged for another. It is the price of one currency in terms of another currency. It is customary to define the exchange rate as the price of one unit of the foreign currency in terms of the domestic currency.
Determination of Equilibrium Exchange Rate:
The exchange rate in free market is determined by the demand and the supply of foreign exchange. The equilibrium exchange rate is the rate at which the demand for foreign exchange equals the supply of foreign exchange. In other words it is the rate which clears the market for foreign exchange. Ranger Narkse the equilibrium exchange rate as “that rate which over a certain period of time keeps the balance of payments in equilibrium”. There are two ways of determining the equilibrium exchange rate. The rate of exchange between foreign currency and domestic currency can be determined either by the demand and supply of foreign currency, with the price of dollars in domestic currency or the demand and the supply of domestic currency with price of domestic currency in foreign currency. Whatever method is adopted, it yields the same result. The analysis that follows is based on the latter measure so that it is explained in the terms of Ponds.
The Demand for Foreign Exchange: The demand for foreign exchange is a derived demand from pounds. It arises from imports of goods and services into the
It implies that the lower the exchange rate on pounds the larger will be the quantity of pounds demanded in the foreign exchange market, and vice versa. This is because a lower exchange rate on pounds makes British exports of goods and services cheaper in terms of dollars. The opposite happens if the exchange rate on pounds is higher. It will make British goods and services dearer in terms of dollars and the demand for pounds will fall in the foreign exchange (
But the shape of demand curve for foreign exchange will depend on the elasticity of demand for imports. In short run elasticity of demand for imports may not very high. In long run however it is much more probable that production pattern will alter according to price changes, and the demand for imports therefore will be more elastic.
The Supply of Foreign Exchange:
The supply of foreign exchange in our case is the supply of pounds. It arises from the
The supply curve for pounds SS is an upward slopping curve, as shown in above figure. It is positive function of exchange rate on pounds. As the exchange rate on pounds increases, the greater is the quantity of pounds supplied in the foreign exchange market. This is because with increase in dollar price of pounds (lower pound price of dollars)
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