Sources of Demand of Foreign Exchange:

The demand (or outflow) of foreign exchange comes from the people who need it to make payments in foreign currencies. The domestic residents for the following reasons demand it:

  • Imports of Goods and Services: When India imports goods and services, foreign exchange is demanded to make the payment for imports of goods and services.
  • Tourism: Foreign exchange is demanded to meet expenditure incurred in foreign tours.
  • Unilateral Transfers Sent Abroad: Foreign exchange is required for making unilateral transfers like sending gifts to other countries.
  • Purchase of Assets in Foreign Countries: It is demanded to make payment for purchase of assets, like land, shares, bonds, etc. in foreign countries.
  • Repayment of loans to Foreigners: As and when we have to pay interest and repay the loans to foreign lenders, we require foreign exchange.
  • Speculation: Demand for foreign exchange arises when people want to make gains from appreciation of currency.

Reasons for ‘Rise in Demand’ for Foreign Currency:

The demand for foreign currency rises in the following situations:

  • When price of a foreign currency falls, imports from that foreign country become cheaper. Therefore, imports increase and hence the demand for foreign currency rises. For example, if price of 1 US dollar falls from Rs.60 to Rs.55, then imports from the USA will increase as American goods will become relatively cheaper. It will raise the demand for US dollar.
  • When a foreign currency becomes cheaper in terms of the domestic currency, it promotes tourism to that country. As a result, demand for foreign currency rises.
  • When price of a foreign currency falls, its demand rises as more people want to make gains from speculative activities.

Demand curve of foreign exchange:

  • Demand curve of foreign exchange slopes downwards due to inverse relationship between demand for foreign exchange and foreign exchange rate.
  • In figure, demand for foreign exchange (US dollar) and rate of foreign exchange are shown on the horizontal axis and vertical axis respectively.
  • The demand curve [US$] is downward sloping. It means that less foreign exchange is demanded as the exchange rate increases.
  • This is due to the fact that rise in the 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.

Sources of supply of foreign exchange: 

The supply (inflow) of foreign exchange comes from the people who receive it due to the following reasons.

  • Exports of Goods and Services: Supply of foreign exchange comes through exports of goods and services.
  • Tourism: The amount, which foreigners spend in the home country, increases the supply of foreign exchange.
  • Remittances (unilateral transfers) from Abroad: Supply of foreign exchange increases in the form of gifts and other remittances from abroad.
  • Loan from Rest of the world: It refers to borrowing from abroad. A loan from U.S. means flow of U.S. $ from U.S. to India, which will increase supply of Foreign exchange.
  • Foreign Investment: The amount, which foreigners invest in our home country, increases the supply of foreign exchange.
  • Speculation: Supply of foreign exchange comes from those who want to speculate on the value of foreign exchange.

Reasons of ‘Rise in Supply’ of foreign currency: 

The supply of foreign currency rises in the following situations:

  • When price of a foreign currency rises, domestic goods become relatively cheaper. It induces the foreign country to increase their imports from the domestic country. As a result, supply of foreign currency rises. For example, if price of 1 US dollar rises from Rs.60 to Rs.65, then exports to USA will increase as Indian goods will become relatively cheaper. It will raise the supply of US dollars.
  • When price of a foreign currency rises, foreign direct investment (FDI) from rest of the world increases, which will increase the supply for foreign exchange.
  • When price of a foreign currency rises, supply of foreign currency also rises as people want to make gains from speculative activities.

Supply curve of foreign exchange:

  • Supply curve of foreign exchange slopes upwards due to positive relationship between supply for foreign exchange and foreign exchange rate, which means that supply of foreign exchange increases as the exchange rate increases.
  • This makes home country’s goods cheaper to foreigners since rupee is depreciating. The demand for our exports should therefore increase as the exchange rate increases.
  • The increased demand for our exports will translate into greater supply of foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate increases.