Exchange Rate Determination

Determination of an Exchange Rate:

In a free market the exchange rate between currencies is determined by demand and supply.

Let’s assume there are just two currencies, the $ and £, and one factor determining exchange rates, trade in goods and services.

Now let’s say I want to start selling Classic American Cars to British consumers. I find the cars I want to buy from an American dealer and agree a price. Unfortunately my American trading partner wants to be paid in $ and not £. Therefore I much exchange my £ for $.

I will therefore supply £ and demand $ on the foreign exchange market.

(Normally I won’t have to worry about arranging the exchange I will just get my bank to transfer the money to the dealers American bank and they will sort out exchange rate for me.)

So how does the above process actually adjust the exchange rate?

When I buy those American cars I am increasing the supply £. This creates an excess of £ on the foreign exchange market.

Banks only make money when the currency is traded. Therefore to shift the extra £ they will lower the exchange rate of the £. The value of the £ will depreciate. The lower priced £ will encourage a greater demand for £ and a new equilibrium will appear.

By contrast by increasing the demand for $ I am creating a shortage of $s. Demand is now greater than supply. To clear the shortage we will see banks adjusting the price of the $ upward, it will appreciate.

This process of adjustment is extremely rapid. Look here to see how the exchange rates fluctuates over a day.

Key terms:

Depreciation: A fall in the free market exchange rate of a currency

Appreciation: A rise in the free market exchange rate of a currency.

If you have any question on the above please do ask in the comments.

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