Posted by Anjali Kaur on Nov 08, 2020

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:

  1. The equilibrium exchange rate is determined at a point where demand for and supply of foreign exchange are equal.
  2. Graphically intersection of the demand and supply curve determines the exchange rate of the foreign exchange market.
  3. 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.
  4. The demand curve is downward sloping and the supply curve is upward sloping. Both intersect each other at point E.
  5. The equilibrium exchange rate is determined is and the equilibrium quantity is.
Foreign Exchange Market
Equilibrium in foreign exchange market

Some of the important terms:

Depreciation

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.

Why?

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.

Devaluation

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.

Appreciation

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:

The foreign exchange rate

The Budget Expenditure

The Budget Deficit

The Government Budget

Working of the Investment

Investment Multiplier

Types of Employment Equilibrium

Concept of Short-Term Equilibrium

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