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Rate of Exchange in Forex

Rate of exchange in a free market is determined by the demand for, and supply of, foreign exchange, or, in other words, by the supply-and-demand for domestic currency.

Every demand for foreign exchange is identical with the supply of domestic currency, and every supply of foreign exchange is identical with the demand for domestic currency.

The demand for, and supply of, foreign exchange arises, mainly speaking, from the following transactions: export and import of goods and services, movement of capital, and movement of gold.

The transactions in any of the three categories mentioned above are not independent of those in other categories. The increase in foreign lending, for instance, may decrease the import of goods and services.

The demand for, and supply of, foreign exchange not only determine the rate of exchange, but are, themselves, influenced by the exchange rate. The volume of demand for, and supply of, foreign exchange will be different at different rates of exchange. Rate of exchange and the demand/supply of foreign exchange act, and react, upon each other.

In fact, the exchange rate, and the actual transactions at this rate, are simultaneously determined by the demand and supply schedules of foreign exchange. When both the countries are on inconvertible paper currencies, the exchange rate is free to move to any point to equilibrate the demand for, and supply of, foreign exchange.

If both the countries are on full gold standard, the rate of exchange is not free to move to any point. It can move only within the limits set by the specie point.

The upper species point is obtained by adding the cost of transferring gold between the two countries to the mint par of exchange, which is arrived at by comparing the amount of gold contained in the unit of each of the two countries.

The lower species point is obtained by deducting the cost of transferring gold from the mint par of exchange.

If the rate of exchange rises above the upper specie point, the gold arbitragers buy gold from the monetary authority, sell it abroad, and supply the obtained foreign exchange to the market.

The supply of foreign exchange becomes infinitely elastic at the upper specie point. Similarly, if the rate of exchange falls below the lower specie point, the gold arbitragers buy foreign exchange, sell it abroad for gold, and sell the obtained gold to the monetary authority, in exchange for domestic currency. Thus the demand for foreign exchange becomes infinitely elastic at the lower specie point.

The market will be unstable if demand exceeds supply at a rate of exchange higher than the equilibrium rate, and supply exceeds demand at a rate of exchange lower than the equilibrium rate.

In an unstable market, any rise in exchange rate above the equilibrium rate will continue without limit, because rise in exchange rate widens the gap between the demand for, and supply of, foreign exchange.

Similarly, all descend in exchange rate below the equilibrium level will continue unchecked, because supply exceeds demand by increasing amounts, with every fall in the exchange rate.