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 U.S. and form capital movements from U.S. to Britain. In fact demand for pounds implies a supply of dollars. When the U.S. businessmen buy British goods and services and make capital transfers to Britain, they create demand for British Pounds in exchange of dollars because they can not make payments to Britain in their currency. In the following figure the demand curve for pounds DD is downward slopping from left to right.

FIG 11

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 (US) market.

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 U.S. exports of goods and services and from capital movements from the U.S. to Britain. Pounds are offered in exchange for dollars because British holders of pound wish to make payments in dollars. Thus the supply of foreign exchange reflects the quantities of pounds that would be supplied in the foreign exchange market at various dollar prices of pounds.

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) U.S. goods, services and capital funds become better bargains to holders of pounds. Therefore, the holders of pound will offer larger quantities of pounds with the increase in the exchange rate.

Equilibrium Exchange Rate: Given the demand and supply schedules of foreign exchange, the equilibrium exchange rate is determined where DD the demand curve for pounds intersects SS the supply curve of pounds. They cut each other at point E in above figure. The equilibrium exchange rate is OR and OQ of foreign exchange id demanded and supplied AOR exchange rate the U.S. demand for pounds equals the British supply of pounds, and the foreign exchange market is cleared. At any higher rate than this, the supply of pounds would be larger than the demand for pounds so that some people who wish to convert pounds into dollars will be unable to do so. The price of pounds will fall, less pounds will be supplied and more will demanded. Ultimately the equilibrium rate of exchange will be re-established in above figure when the exchange rate increases to OR`, the supply of pounds R`B>R`A the demand for pounds. With the fall in the price of pounds, the equilibrium exchange rate O`R is again established at point E. On the contrary at an exchange rate lower than this, say OR1, the demand for pounds R1H is greater than the supply of pounds R1G. Some people who want pounds will reduce the demand and increase the supply of pounds so that the equilibrium exchange rate OR is re-established at point E where the two curves DD and SS intersect.

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