Equilibrium in the foreign exchange market
Foreign of exchange market is that market where currencies of 1 country are traded for another country’s currencies. Let’s understand the equilibrium in the foreign exchange market.
Let’s understand this topic in detail.
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First observe the diagram of the foreign exchange market:
- The equilibrium exchange rate is determined at a point where demand for and supply of foreign exchange are equal.
- Graphically intersection of the demand and supply curve determines the exchange rate of the foreign exchange market.
- As shown in the diagram, the demand, and supply of the foreign exchange rate are measured on the x-axis, the rate of the foreign exchange is measured on the y-axis.
- The demand curve is downward sloping and the supply curve is upward sloping. Both intersect each other at point E.
- The equilibrium exchange rate is determined is and the equilibrium quantity is.
Some of the important terms:
Depreciation is the fall in the value of the domestic currency in relation to foreign currency. For example, the Indian rupee depreciated from 70 INR to 1 USD, to 80 INR to 1 USD.
INR is depreciating because now Indians have to pay 80 INR to buy 1 USD.
Depreciation of rupees
It is the fall in the value of the Indian currency in relation to the foreign currency, that is, more rupees are required to buy a unit of foreign currency or USD can be exchanged by paying more rupees.
It refers to a planned fall in the value of the domestic currency in relation to foreign currency when the exchange rate is fixed by the government.
Why devaluation is done?
The government of a country declares a cut in the value of a domestic currency with a view to increase exports and decrease imports for the balance of payment deficit corrections.
It refers to a rise in the value of the domestic currency in relation to the foreign currency. For example, if the exchange rate becomes INR 40 for 1 USD. So, in this case, imports will rise and exports will fall.
An increase or decrease in foreign exchange does not directly impact the national income of a country. But it has an indirect impact on the imports or exports of the country.
Both devaluation and depreciation lead to a fall in the domestic currency in relation to foreign currency. This means that a domestic currency becomes cheaper in terms of foreign currency and exports increases.
Thank You for reading.
You can read the related post on macroeconomics:
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