Class 12 Macro Economics Notes · CBSE
Determination and Changes in Exchange Rate
Equilibrium exchange rate from demand-supply intersection, excess demand and supply adjustment mechanisms, and how shifts in demand and supply curves alter equilibrium. CBSE Class 12 Macroeconomics notes.
Notes
Equilibrium Exchange Rate
In a Flexible Exchange Rate System, the exchange rate is determined by the interaction of the forces of demand and supply, much like the price of any commodity. The equilibrium exchange rate is found at the level where the quantity of foreign exchange demanded equals the quantity supplied.
The flexible rate of exchange is also called the 'Free rate of Exchange' because it is determined freely by market forces.
Why Other Rates Are Not Equilibrium
Excess Supply (Rate Above Equilibrium)
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If the exchange rate is above the equilibrium rate (e.g., at OR₂), the quantity of foreign exchange supplied (OQ₁) is greater than the quantity demanded (OQ₂). This excess supply puts downward pressure on the exchange rate, causing it to fall back towards the equilibrium rate OR.
Change in Demand — Increase
An increase in the demand for foreign exchange shifts the demand curve to the right, from DD to D₁D₁. At the original exchange rate OR, there is now excess demand (QQ₃). This excess demand causes the exchange rate to rise to OR₁. A rise in the price of the foreign currency (US Dollar) in terms of the domestic currency (Rupees) means the domestic currency has depreciated.
Change in Demand — Decrease
A decrease in demand shifts the demand curve to the left, from DD to D₂D₂. This creates deficit demand at the original exchange rate OR. As a result, the exchange rate falls to OR₂. A decrease in the price of the foreign currency (US Dollar) in terms of the domestic currency (Rupees) means the domestic currency has appreciated.
Change in Supply — Increase
If the supply of foreign exchange increases, the supply curve shifts to the right, from SS to S₁S₁. At the original exchange rate OR, there is now excess supply. This excess supply causes the exchange rate to fall to OR₁. A decrease in the price of the foreign currency means the domestic currency has appreciated.
Change in Supply — Decrease
A decrease in the supply of foreign exchange shifts the supply curve to the left, from SS to S₂S₂. At the original exchange rate OR, there is now deficit supply. This deficit supply increases the exchange rate to OR₂. An increase in the price of the foreign currency means the domestic currency has depreciated.