Give the meaning of foreign exchange and foreign exchange rate. Giving reason, explain the relation between foreign exchange rate and demand for foreign exchange.
Foreign exchange It refers to the stock of foreign currency with the domestic currency. Foreign exchange plays a key role in international transactions. For India, all the currencies other than Indian rupee are foreign exchange.
Foreign exchange rate It is the rate at which one currency is exchanged for other currency in the foreign exchange market. It is the rate at which one unit of a foreign currency is exchanged for domestic currency, e.g. if Rs 50 is paid to buy one US dollar, then the exchange rate between the two currencies are 50 : 1 or 1 =Rs 50.
Relation between foreign exchange rate and demand for foreign exchange There is an inverse relationship between the foreign exchange rate and demand for foreign exchange.
In the given figure, DD curve represents the demand for foreign currency. When exchange rate rises to R_1, demand for the foreign currency falls to Q_1. On the other hand, when exchange rate falls to R_2 demand for the foreign currency rises to Q_2.
The demand curve for the foreign currency is always downward sloping and signifies an inverse relationship between demand and exchange rate. A rise in exchange rate means that greater units of domestic currency is required to be paid for same unit of foreign currency. This makes import costlier. As a result, import falls leading to a fall in the demand for foreign, exchange.