BoP Approach of Echange Rate Determination

BoP Approach
What happens if the exchange rate is not the Equilibrium exchange rate?
Case I: At the exchange rate higher than the equilibrium exchange rate,
say OR2, there will be excess supply, i.e., Q1Q2. This is so because there is a
positive relationship between the price of foreign exchange and the quantity
supplied. Thus, if the exchange rate rises, the quantity supplied also increases.
On the other hand, demand will fall to OQ2, as there is a negative relationship
between the price of foreign exchange and the quantity demanded. Thus, the
excess supply with the fall in demand for foreign exchange will push down the
rate of foreign exchange (this indicates that the Indian Rupee will appreciate).
It will again lead to an increase in demand from OQ2 to OQ, and a decrease in
supply from OQ1 to OQ till it reaches equilibrium E.
Case II: Conversely, at the exchange rate lower than the equilibrium exchange
rate says OR1, there will be excess demand, i.e., Q1Q2. This is so because there
is a negative relationship between the price of foreign exchange and the
quantity demanded. Thus, if the exchange rate falls, the quantity demanded
increases. On the other hand, supply will fall to OQ2, as there is a positive
relationship between the price of foreign exchange and the quantity supplied.
Thus, the excess demand with an increase in the demand for foreign exchange
will push up the rate of foreign exchange (this indicates that the Indian Rupee
will depreciate). It will again lead to a decrease in demand
from OQ1 to OQ and an increase in supply from OQ2 to OQ till it reaches
equilibrium E.
Changes in Exchange Rate

The foreign exchange rate may rise or fall depending upon the changes in
demand and supply of foreign exchange.
1. Change in Demand
Change in Demand may be either an “Increase in Demand” or a “Decrease in

Demand”
Change in demand is demonstrated in Fig 2. On the Y axis, the Rate of the
exchange is shown and on the X axis, the Demand and Supply of foreign
exchange are shown. DD is the demand curve and SS supply curve. Both
curves (demand and supply) intersect each other at point E. Thus, E is the
Equilibrium point. Equilibrium E corresponds to the OR Rate of foreign
exchange rate and OQ quantity demanded.
Fig 2: Change in Demand
Increase in Demand:
The increase in the demand for foreign exchange will shift the demand curve
from DD to D1D1. It can be seen in Fig 2 that due to a shift in the demand
curve, the supply curve will now meet the demand curve at E1, which will be
the new Equilibrium point. Now, at the new equilibrium point, the exchange
rate will increase to OR1 with quantity demanded as OQ1. It means that with an
increase in demand, the exchange rate will also increase.
Decrease in Demand:
The decrease in the demand for foreign exchange will shift the demand curve
from DD TO D2D2. It can be seen in Fig 2 that due to a shift in the demand
curve, the supply curve will now meet the demand curve at E2, which will be
the new Equilibrium point. Now, at the new equilibrium point, the exchange
rate will decrease to OR2 with quantity demanded as OQ2. It means that with a
decrease in demand, the exchange rate will also decrease.
Change in Supply
Change in Supply may be either an “Increase in Supply” or a “Decrease
in Supply”.
Change in supply is demonstrated in Fig 3. On the Y axis, the Rate of
exchange is shown and on the X axis, the Demand and Supply of foreign
exchange are shown. DD is the demand curve and SS supply curve. Both
curves (demand and supply) intersect each other at point E. Thus E is the
Equilibrium point. Equilibrium E corresponds to the OR Rate of foreign
exchange rate and OQ quantity supplied.
Fig 3: Changes in Supply
1. Increase in Supply:
The increase in the supply of foreign exchange will shift the supply curve
from SS to S1S1. It can be seen in Fig 3 that due to a shift in the supply curve,
the demand curve will now meet the supply curve at E1, which is the new
Equilibrium point. Now, at the new equilibrium point, the exchange rate will
decrease to OR1 with quantity demanded as OQ1.. It means that with an
increase in supply, the exchange rate will decrease.
2. Decrease in Supply:
The decrease in the supply of foreign exchange will shift the supply curve
from SS to S2S2. It can be seen in Fig 3 that due to a shift in the supply curve,
the demand curve will now meet the supply curve at E2, which is the new
Equilibrium point. Now, at the new equilibrium point, the exchange rate will
increase to OR2 with quantity demanded as OQ2. It means that with a decrease
in supply, the exchange rate will increase.

BoP Approach of Echange Rate Determination

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BoP Approach of Echange Rate Determination

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BoP Approach

Changes in Exchange Rate

Change in Demand may be either an “Increase in Demand” or a “Decrease in

Fig 3: Changes in Supply

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