Question

Give the meaning of ‘foreign exchange’ and ‘foreign exchange rate’. Giving reason, explain the relation between foreign exchange rate and demand for foreign exchange.

Answer 1

Foreign exchange refers to the stock of foreign currencies held by the monetary authority of the country. It consists of the stock of currencies of the different countries of the world. On the other hand, foreign exchange rate is the rate at which price of one currency is measured in terms of another currency. It shows the price paid in domestic currency to purchase one unit of foreign currency.

The foreign currency is demanded for the purpose of making payments of various economic and monetary transactions such as for purchasing goods and services from the rest of the world, repayment of loans and borrowings, sending gifts and grants to the rest of the world, for the purpose of investment and purchase of financial assets in rest of the world etc.

Demand for foreign currencies is inversely related with the exchange rate. In other words, higher the exchange rate, lower will be the demand for foreign currencies and vice-versa. A rise in the exchange rate (from say, $1= Rs 40 to $1= Rs 50) implies that the goods from abroad become more expensive (that is, it now cost Rs 50 to purchase a commodity worth $1 instead of Rs 40 earlier). This would result in a reduction in the demand for the foreign commodities. This fall in the demand for foreign goods reduces the demand for dollars and vice-versa.

Graphically, the demand curve for foreign currency is represented as follows.

In the above figure, demand for foreign exchange is represented on x-axis and exchange rate on y-axis. The demand curve for exchange rate is the negatively sloped DD curve.