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Unit 3: Foreign Exchange Market and Exchange Rates

exchange rate, R = $/£ and the horizontal axis measures the quantity of pounds. The equilibrium Notes
exchange rate is determined by the intersection of the market demand and supply curves for
pounds at point E, i.e., at R = 2. At this point, the quantity of pounds demanded and the quantity
of pounds supplied are equal to £40 million per day. At an exchange rate lower than R = 2 or at
an exchange rate higher than R = 2, the quantity of pounds demanded will not match with the
quantity of pounds supplied and the tendency for the exchange rate will be to move towards
R = 2.
The US demand for pounds is negatively inclined, indicating that the lower the exchange rate
(R), the greater is the quantity of pounds demanded by the US. The reason is that the lower is the
exchange rate (i.e., the fewer the number of dollars required to purchase one pound), the cheaper
it is for the US to import from and to invest in the UK and thus, the greater is the quantity of
pounds demanded by US residents. On the other hand, the US supply of pounds is usually
positively inclined (as in the figure), indicating that the higher the exchange rate (R), the greater
is the quantity of pounds earned by or supplied to the US. The reason is that at higher exchange
rates, UK residents receive more dollars for each of their pounds. As a result, they find US goods
and investments cheaper and more attractive and spend more in the US, thus supplying more
pounds to the US.

If the US demand curve for pounds shifted upwards (for example, as a result of increased US
tastes for British goods) and intersected the US supply curve for pounds at point G, the equilibrium
exchange rate would be R=3 and the equilibrium quantity of pounds would be £60 million per
day. The dollar would then be said to have depreciated since it now requires three (instead of the
previous two) dollars to purchase one pound. Depreciation thus refers to an increase in the
domestic price of the foreign Currency. On the other hand, if the US demand curve for pounds
shifted down so as to intersect the US supply curve for pounds at point H (Figure 3.1), the
equilibrium exchange rate would fall to R = 1, and the dollar would be said to have appreciated
(because fewer dollars are now required to purchase one pound). Appreciation thus refers to a
decline in the domestic price of the foreign Currency. An appreciation of the domestic Currency
means a depreciation of the foreign Currency and vice versa. Shifts in the US supply curve for
pounds would similarly affect the equilibrium exchange rate and equilibrium quantity of pounds.
The above discussion only deals with two currencies. However, in reality, there are a number of
exchange rates, one between any pair of currencies. That is, besides the exchange rate between
the US dollar and the British pound, there is an exchange rate between the US dollar and the
Indian rupee, between the US dollar and the French franc, between the British pound and the
French franc, between the British pound and the Indian rupee and so on. Since a Currency can
depreciate with respect to some currencies and appreciate against others, an effective exchange
rate is calculated. This is a weighted average of the exchange rates between the domestic Currency
and the nations’ most import trade parties, with weights being assigned according to the relative
importance of the nations’ trade with each of these trade partners.

Arbitrage

The term “Arbitrage” refers to the purchase of a Currency by Speculators in the monetary centre
where it is cheaper for immediate resale in the monetary centre where it is more expensive so as
to make a profit. The process of Arbitrage helps in keeping the exchange rate between any two
currencies the same in different monetary centres.

Example: If the dollar price of pounds were $1.98 in New York and $2.01 in London, an
arbitrager (usually a commercial bank or a foreign exchange dealer) would purchase pounds at
$1.98 in New York and immediately resell them in London for $2.01, thus realising a profit of
$0.03 per pound. If the transaction involved £1 million, the profit would be $30,000 for only a

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