Chapter 23: Problem 4

Explain the determination of the demand for foreign exchange in a flexible or floating exchange rate system.

Short Answer

Expert verified

Answer: The three major factors that influence the demand for foreign exchange in a floating exchange rate system are imports, international investments, and economic conditions. These factors interact in the foreign exchange market to determine the actual demand for foreign exchange. An increase in imports or international investments, or high inflation, can lead to a higher demand for foreign exchange, putting upward pressure on the exchange rate and causing the domestic currency to depreciate. Conversely, a decrease in imports or international investments, or an improvement in economic conditions, can lead to lower demand for foreign exchange, causing the exchange rate to fall and the domestic currency to appreciate. The exchange rate fluctuates as the demand for foreign exchange shifts based on changes in these factors.

Step by step solution

Introduction to the floating exchange rate system

In a floating exchange rate system, the value of a currency is determined by the supply and demand for that currency in the foreign exchange market. The exchange rate fluctuates based on market conditions, without any intervention from governments or central banks. Now, let's focus on understanding the demand side of the foreign exchange market.

Factors influencing the demand for foreign exchange

In a floating exchange rate system, the demand for foreign exchange is influenced by several factors. Major factors include imports, international investments, and economic conditions. Changes in these factors lead to shifts in demand for foreign exchange.

Demand for foreign exchange due to imports

When a country imports goods and services, it needs to pay for them in the currency of the exporting country. So, an increase in imports increases the demand for foreign exchange, as more domestic currency needs to be exchanged for the foreign currency of the exporting country. Conversely, a decrease in imports leads to a decrease in demand for foreign exchange.

Demand for foreign exchange due to international investments

Investors and firms in a country may invest in foreign financial assets like stocks, bonds, or direct investment in foreign businesses. To do so, they need to exchange their domestic currency for the foreign currency of the country they are investing in. An increase in outward investment will result in an increase in demand for foreign exchange, while a decrease would have the opposite effect.

Demand for foreign exchange due to economic conditions

Economic conditions in a country can also affect the demand for foreign exchange. If a country experiences high inflation, its currency loses value relative to other currencies. This will lead to an increase in demand for foreign exchange, as people and firms look for more stable currencies to hold. Additionally, if a country experiences a recession or a decline in economic growth, it may lead to lower demand for foreign exchange, as imports and international investments are likely to decrease.

Interaction of factors in determining demand for foreign exchange in a floating exchange rate system

In a floating exchange rate system, the actual demand for foreign exchange is determined by how these factors (imports, international investments, and economic conditions) interact with each other and affect the foreign exchange market. When the demand for foreign exchange increases, it puts upward pressure on the exchange rate, making the domestic currency depreciate relative to the foreign currency. Conversely, when the demand for foreign exchange decreases, the exchange rate falls, making the domestic currency appreciate. The exchange rate will fluctuate as the demand for foreign exchange shifts based on changes in these factors.

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