Determinant of Foreign Exchange Rate

Determination of foreign exchange rate

Prices of goods, commodities and exchange rates are determined on open markets under the control of two forces, supply and demand.

The laws of supply and demand show that:

• High supply causes low prices, and high demand causes high prices.

• When there is an abundant supply of a given commodity then the price should fall.

• When there is a scarce supply of a given commodity then the price should increase.

• Therefore, an increase in the demand for a commodity would cause it to appreciate in value, whereas an increase in supply would cause it to depreciate.

The value of a nation’s currency, under a floating exchange rate, is determined by the interaction of supply and demand. We will work through some charts and an example to show how these forces work, from a theoretical point of view.

Demand Curve

[pic]Figure 1 shows the demand for British pounds in the United States. The curve is a normal downward sloping demand curve, indicating that as the pound depreciates relative to the dollar, the quantity of pounds demanded by Americans increases. Note that we are measuring the price of the pound-the exchange rate-on the vertical axis. Since it is dollars per pound ($/£), it is the price of a pound in terms of dollars and an increase in the exchange rate, R, is a decline in the value of the dollar. In other words, movements up the vertical axis represent an increase in price of the pound, which is equivalent to a fall in the price of the dollar. Similarly, movements down the vertical axis represent a decrease in the price of the pound.

For Americans, British goods are less expensive when the pound is cheaper and the dollar is stronger. At depreciated values for the pound, Americans will switch from American-made or third-party suppliers of goods and services to British suppliers. Before they can purchase goods made in Britain, they must exchange dollars for British pounds. Consequently, the increased...