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Foreign Exchange Rate Determination
Foreign Exchange Rate Determination
TERMINOLOGIES
Foreign Exchange rate
Foreign exchange rate is the rate at which one
currency is exchanged for other.
It is the price of one currency in term of other
The exchange rate between dollar and pound
refers to numbers of dollars required to
purchased one pound
For example if $2.50=1
Foreign Exchange:
The exchange rate of $2.50=1 or
Foreign Exchange:
Arbitrageurs will buy pounds in London and sell
them in new York for earning profit
As a result the price of ponds in term of dollars in
London market rises and falls in the new York
market
This process will end the arbitrage practice
Determination of equilibrium
exchange rate
The exchange rate in a free market is determined by
the demand and supply of foreign exchange
Equilibrium exchange rate is a rate at which demand
for foreign exchange is equal to supply of foreign
exchange
It is the rate which clears the foreign exchange
market
Two method for clearing the market
A) Demand and supply of dollars with price of dollars
in pounds
B) Demand and supply of pounds with price of pounds
in dollarsboth method yields same result
Determination of equilibrium
exchange rate (cont)
1) Demand for foreign exchange
The demand for foreign exchange (pounds) is a derived
from demand from pounds
It arises from import of British goods and services into
U.S and from capital movements from the U.S to Britain
Demand for pounds implies supply of dollars
When U.S businessmen buy British goods and services
and make capital transfers to Britain they create
demand for British pounds in exchange for U.S dollars
Determination of equilibrium
exchange rate (cont)
Demand curve for pounds DD is sloping
downward from left to right
It means that lower the exchange rate on
pounds( pounds became cheaper) (dollars
price of pound) the larger will be demand
for pounds in foreign market
This means that British exports of goods
and services cheaper in term of dollars
The opposite happens if exchange rate on
pounds (dollars price of pound) is higher
It will make British goods and services
dearer
Determination of equilibrium
exchange rate (cont)
Supply of foreign exchange
Supply of foreign exchange in our case is the supply of
pounds
It arises from U.S exports of goods and services to Britain
and capital movement from U.S to Britain
British holders of pounds wish to make payment in $, thus
supply of pounds in market will increase
Supply curve for pounds SS is an upward sloping curve
The relation between exchange rate on pounds (dollar
price of pounds) and supply of pounds is positive
If exchange rate on pounds increases U.S goods and
services become cheaper in Britain ,they would purchase
more and as a result supply of pounds in a market
increase
Determination of equilibrium
exchange rate (cont)
Dollar price of pounds
Exchange rate
R2
R1
S
pounds
Determination of equilibrium
exchange rate (cont)
Given the demand and supply curve for foreign
exchange, the equilibrium exchange rate is determined
where demand for pounds intersects supply of pounds
Equilibrium exchange rate is R and OQ shows
equilibrium demand and supply of foreign exchange
rate
If exchange rate is higher than equilibrium exchange
rate it means that supply of pounds is greater than
demand for pounds
The price of pounds will fall and ultimately equilibrium
exchange rate will reach and economy will come back
to equilibrium point i.e point E
Determination of equilibrium
exchange rate (cont)
An exchange rate lower than equilibrium rate
mean demand for foreign exchange rate is
greater than supply of foreign exchange rate
This leads to increase the price of pounds in
foreign exchange market
so exchange rate will tends to increase and
equilibrium rate will re-established in market
Theories of Foreign
Exchange
1:The Mint Parity theory
2: The purchasing Power Parity Theory
3: The Balance of Payments theory
12
16
18
PPP Theory
19
AB
= PA /PB
P1b/P0
Explanation (PPP)
The exchange rate would be a proper
reflection of the purchasing power in
each country if the relative values
bought the same amount of goods in
each country.
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Exchange rate
R2
R1
S
Dollars