question_answer

Why does the demand for foreign currency fall and supply rises when its price rises? Explain.

Answer:

Foreign exchange rate shares an inverse relationship with the demand for the currency. With a fall in the price of foreign exchange, value of domestic currency increases (i.e. appreciation of domestic currency) and that means foreign goods become cheaper and their domestic demand (i.e. imports) increases.                                     The rising domestic demand for foreign goods implies higher demand for foreign exchanges which increases from   to   as shown in the figure. Quantity of foreign exchange Demand Curve of Foreign Exchange The supply of foreign currency is directly proportional to the price of foreign exchanges. When the price of a foreign currency falls, it leads to cheaper imports because it leads to appreciation of domestic currency. The exporters are discouraged due to costlier exports. This results in lesser inflow or supply foreign currency in the economy. As a result, supply of foreign exchange decreases from to as shown in the figure. Supply of foreign currency Supply Curve of Foreign Exchange