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Home » Economics Homework Help » Macroeconomics Help » Exchange Rate Change
Exchange Rate Change
The foreign exchange market conditions are however not static. They are subject to change due to changing domestic and external economic conditions. Therefore, market determined exchanged rate is subject to frequent variations due to the following factors.

(i) Change in domestic prices: a change in domestic prices, foreign prices remaining constant, changes the demand and supply conditions of foreign exchange. For example, a rise in domestic prices in India, all other things remaining the same, reduces foreign demand for Indian goods and increases India’s demand for foreign goods. Consequently, India’s imports increase causing an increase demand for foreign exchange and an upward shift in the India’s demand curve. For the same reason, India’s exports decrease causing a left ward shift in her foreign exchange supply curve. Both these changes cause a change the exchange rate.

(ii) Change in the real income: a change in real income of a country, other factors remaining the same, increases its demand for both domestic and foreign goods. Demand for foreign goods increases because, in general, imports are income elastic. Increase in imports increases demand for foreign exchange and, therefore, the exchange rate. For example, if real income of India increases, ceteris paribus, her imports increase because they are income-elastic. Increase in imports increases India’s demand for foreign exchange. This makes the demand curve shift upward causing a rise in the exchange rate. Similarly, when real income of foreign countries increases, ceteris paribus, it results in appreciation of Indian currency.

(iii) Change in the rate of interest: change in the interest rate in different countries affects the capital flows between the nations and the demand and supply conditions. Capital tends to flow from low-interest-rate countries to the high-interest-rate countries. The change in the pattern of capital flow leads to a change in demand and supply conditions for foreign exchange which changes the exchange rate. For instance, India had experienced a similar change in rupee-dollar exchange rate in 2008. Due to rapid inflow of financial institutional investment (FII) demand for Indian currency had increases and, therefore, the dollar price had declined from about Rs.. 50 per dollar to about Rs.40.

(iv) Structural change: The structural changes in an economy, for example, change in the composition of GNP and technological and industrial innovations, and change the cost structure of a country which in its turn changes the relative price structure. Such changes cause a change in the demand and supply conditions and hence a change in the exchange rate.

(v) Speculative demand and supply: the speculative demand for and supply of foreign exchange too change the position of the demand and supply curves and therefore the exchange rate.

The factors noted above keep exchange rate floating. Such an exchange rate is called floating exchange rate. However, it is argued that if foreign exchange market is perfectly competitive, there will always be an order in the foreign exchange market and a stable exchange rate. Whether exchange rate remains over a period of time depends on the market conditions.

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