Understanding the Supply of Foreign Exchange

The supply of foreign exchange refers to the amount of foreign currency (like US dollars or Euros) that becomes available to a country's residents during a specific period. This supply primarily originates from various international transactions where domestic residents receive foreign currency.

Sources of Supply of Foreign Exchange

Key sources contributing to the supply of foreign exchange for a country include:

• Exports of Goods and Services: When a country exports goods and services, foreign buyers pay in foreign currency, which is then converted into domestic currency by the exporters.
• Remittances: Money sent by non-resident citizens living abroad to their families in the home country.
• Foreign Investment: Inflows of foreign direct investment (FDI) or foreign portfolio investment (FPI) into the country.
• Tourism: Spending by foreign tourists visiting the country.
• Borrowings from Abroad: Funds borrowed by the government or domestic firms from foreign sources.

The Relationship Between Exchange Rate and Foreign Exchange Supply

The exchange rate is the price of one currency in terms of another. For instance, if the exchange rate is $1 = €0.90, it means one US dollar can buy 0.90 Euros.

Consider the supply of foreign exchange (say, $) from India's perspective. The exchange rate is expressed as Rupees per Dollar (e.g., Rs. 80 per $). When the exchange rate (Rs. per $) increases, it means the Dollar becomes more expensive in terms of Rupees, or equivalently, the Rupee becomes cheaper in terms of Dollars.

A higher exchange rate (Rupee depreciation) makes India's exports cheaper for foreign buyers. For example, if a product costs Rs. 800, it costs $10 when the rate is Rs. 80/$. If the rate increases to Rs. 82/$, the same product costs only $800/82 ≈ $9.76. Cheaper exports can lead to an increase in the quantity of goods and services demanded by foreigners, thus increasing the supply of foreign exchange ($) flowing into India.

Similarly, a higher exchange rate might encourage more foreign investment as foreign capital can buy more domestic assets with the same amount of foreign currency. Tourism might also increase as the country becomes a cheaper destination for foreigners.

Therefore, as the exchange rate (price of foreign currency) increases, the quantity of foreign exchange supplied tends to increase, all other factors remaining constant.

Shape of the Supply Curve of Foreign Exchange

Based on the positive relationship between the exchange rate and the quantity of foreign exchange supplied, the supply curve of foreign exchange is depicted graphically with the exchange rate on the vertical axis and the quantity of foreign exchange on the horizontal axis.

Since a higher exchange rate leads to a greater quantity supplied, the supply curve slopes upwards from left to right.

This upward slope indicates a direct relationship between the price of foreign exchange and the amount offered for sale in the foreign exchange market.

Revision Table: Foreign Exchange Supply Curve

Additional Information: Market Equilibrium and Shifts

The foreign exchange market also has a demand side, represented by the demand curve for foreign exchange. This curve is typically downward sloping, indicating that as the price of foreign exchange increases, the quantity demanded decreases (because imports become more expensive, and capital outflows become less attractive).

The equilibrium exchange rate is determined at the intersection of the demand and supply curves of foreign exchange. Changes in factors other than the exchange rate that affect the supply (like changes in foreign income affecting exports, or changes in investor confidence affecting capital inflows) will cause the entire supply curve to shift.

An increase in the supply of foreign exchange shifts the supply curve to the right, while a decrease shifts it to the left.