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Chapter 9 Foreign Exchange Rate Solutions

Question - 1 : - How is exchange rate determined under a flexible exchange rate regime? 

Answer - 1 : -

  1. Exchange rate in a free exchange market is determined at a point, where demand for foreign exchange is equal to the supply of foreign exchange.
  2.  Let us assume that there are two countries – India and U.S.A – and the exchange rate of their currencies i.e., rupee and dollar is to be determined.
  3. Presently, there is floating or flexible exchange regime in both India and U.S.A. Therefore, the value of currency of each country in terms of the other currency depends upon the demand for and supply of their currencies.
  4. In the above diagram, the price on the vertical axis is stated in terms of domestic currency (that is, how many rupees for one US dollar). The horizontal axis measures the quantity demanded or supplied.
In the above diagram, the demand curve [D$] is downward sloping. This means that less foreign exchange is demanded as the exchange rate increases. This is due to the fact that the rise in price of foreign exchange increases the rupee cost of foreign goods, which make them more expensive. As a result, imports decline. Thus, the demand for foreign exchange also decreases.
The supply curve [S$] is upward sloping which means that supply of foreign exchange increases as the exchange rate increases. This makes home country’s goods become cheaper to foreigners since rupee is depreciating in value. The demand for our exports should therefore increase as the exchange rate increases. The increased demand for our exports translates into greater supply of foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate increases.
                                
 The intersection of the supply and demand curves determine equilibrium exchange rate (OP$) and equilibrium quantity [OQ$] of foreign currency i.e., US [$].


Question - 2 : - Are the concepts of demand for domestic goods and domestic demand for goods the same?

Answer - 2 : -

  1. Demand for domestic goods and domestic demand for goods are two different concepts.
  2. Demand for domestic goods is a demand for goods made by both domestic and foreign countries.
  3. Domestic demand for goods is a demand for goods by our own country for goods ..which may be produced in foreign countries.

Question - 3 : - Would the central bank need tointervene in a managed floating system? Explain why?

Answer - 3 : -

  1.  In a managed floating system a central bank of a country has freedom to bring change in the exchange rate within certain limits.
  2. A country is allowed after information to the IMF to bring a certain limited amount of change in the rate of exchange.
  3.  A central bank cannot bring change in its exchange rate by more than 10%. For it, permission of IMF is necessary.

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