Why are foreign exchange rate and supply of foreign exchange directly related? Explain.
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When foreign exchange rate rises, domestic goods becomes cheaper for foreign buyers. This raises demand for exports causing rise in supply of foreign exchange (when foreign exchange rate falls, domestic goods become costlier for foreign buyers decreasing demand for the exports causing fall in supply of foreign exchange.)
(Explanation based on anyone, rise or fall in foreign exchange rate, is enough to attract full credit.)
Detailed Answer:
Fall in the price of a foreign currency causes a fall in its supply owing to the following reasons:
(i) Now domestic currency becomes dearer in relation to the foreign currency. Accordingly, foreign investors will make smaller investment in the domestic economy. Implying, a fall in the supply of foreign currency.
(ii) Now domestic exports will fall because one US dollar buys less goods in the domestic market. Accordingly, supply of foreign currency (or flow of foreign currency into our economy) will fall.
(iii) Fall in the price of a foreign currency (say US dollar) would mean less Indian rupees per US dollar. Accordingly, NRIs would make less transfers to their home country. Implying, a fall in the flow of foreign currency into the domestic economy.
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