question_answer

How is exchange rate determined under flexible exchange rate system? Also enumerate the sources of demand and supply of foreign exchange. If demand for foreign exchange is continuously rising then which economic value stands affected?

Answer:

Foreign exchange rate is determined by the demand and supply of foreign exchange. The rate of foreign exchange is said to be in equilibrium, when the demand for some currency in terms of another currency equals its supply. Demand and supply of foreign exchange In the given figure, the line SS shows the supply of foreign currency which is positively related to the rate exchange. The line DD shows the demand for foreign currency which is negatively related to the rate of exchange. The point E, at which demand is equal to supply, represents the equilibrium rate of exchange. Sources of Demand for Foreign Exchange                                               Foreign exchange is demanded for the following purposes:                                        (i) Purchase of foreign goods by domestic residents, i.e. imports.                                 (ii)  Payments of international loans.                                                             (iii) Gifts and grants to the rest of the world.                                                      (iv) Investments in the rest of the world.                                                          (v) Tourism to abroad.                                                                       Sources of Supply of Foreign Exchange                                                  Supply of foreign exchange depends on the following factors:                                      (i) Purchases of domestic goods by the foreigners, i.e. exports.                                   (ii) Foreign Direct Investment as well as portfolio investment from rest of the world,                 (iii) Speculative purchases of foreign exchange,                                                (iv) Tourism and remittances from abroad.                                                       (v) Transfer of foreign exchange by the residents of the country abroad.      If demand for foreign exchange is rising continuously then this leads to an unfavourable exchange This affects the goodwill of the domestic currency in the international market.