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Question

(a) Why is demand curve of foreign exchange negatively sloped? 

(b) Why is supply curve of foreign exchange positively sloped? 


Solution

(a) Demand curve : 
Exchange rate measures the effective cost of goods and services available abroad. Higher the exchange rate, lower the demand for imported commodities and hence, the demand for foreign currency falls. Similarly lower the exchange rate, higher the demand for imported commodities and hence the demand for foreign currency is higher. Thus, there is an inverse relationship between foreign exchange rate and foreign exchange and hence, demand curve is downward sloping. There are two reasons of rise in demand when the exchange rate falls (inverse relationship).

(1) When the price of foreign currency falls imports from that country become cheaper. 

(2) It promotes tourism to that country. 

(b) Supply curve: The major component of the supply of foreign currency is the exports of a country's goods and services. Higher the exchange rate higher will be the export and supply of foreign exchange. Thus, the supply curve of foreign currency is upward sloping. Also when the foreign exchange rate rises, more foreigners will be attracted to the domestic country. This will further increase the supply of foreign currency.

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