Determination of Exchange Rate in Spot Market

In a Floating Rate system, the Exchange Rate is a price. Like the price of potatoes, it is determined by Demand and Supply.

1. Demand for Foreign Currency (Why do we buy $?)

The Demand Curve is Downward Sloping.

• Importers: Need $ to pay for goods. If $ is cheap, they import more -> High Demand.
• Tourists: Need $ to travel.
• Investors: Need $ to buy US stocks.

2. Supply of Foreign Currency (Who sells $?)

The Supply Curve is Upward Sloping.

• Exporters: Earn $ and sell it to buy Rupees. If $ is expensive (Rs 85), they are happy to sell more.
• Foreign Tourists: Bring $ to India.
• FDI Investors: Bring $ to invest in India.

3. Equilibrium Determination

Loading diagram…

Impact of Shifts

• If Demand Increases (e.g., Oil Price rises, we need more $):
  • Demand curve shifts Right.
  • New Equilibrium is at a Higher Rate (e.g., ₹85). Rupee Depreciates.
• If Supply Increases (e.g., Huge FDI inflow):
  • Supply curve shifts Right.
  • New Equilibrium is at a Lower Rate (e.g., ₹80). Rupee Appreciates.

4. Exam Notes: Writing the Answer

Question: "Explain how exchange rate is determined in a free market." (10 Marks)

Answering Strategy:

1. Graph: You MUST draw a Demand/Supply cross graph (X-axis: Quantity of $, Y-axis: Exchange Rate ₹/$).
2. Explanation: Explain why Demand is downward and Supply upward.
3. Equilibrium: Define the intersection point.
4. Factors: Briefly mention 1 factor shifting demand (e.g., Imports).

Summary

• Price Mechanism: No government sets the rate. The collective action of millions of traders sets it.
• Self-Correction: If rate is too high, supply increases and demand drops, bringing rate back down.

Quiz Time! 🎯

Loading quiz…