Given a currency pair, what happens to the exchange rate if the foreign exchange market is...

Given a currency pair, what happens to the exchange rate if the foreign exchange market is in disequilibrium? Does it matter if the exchange rate is above or below the equilibrium rate? Understand what market forces drive the exchange rate back to equilibrium in both cases, whether or not the cases are different.

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Expert Solution

The foreign exchange market is in disequilibrium implies there is a deficit or surplus in the current account balance of payment,i.e., the receipts are less than the payments or vice versa respectively. Given a currency pair, if balance of payment is in disequilibrium then government can correct the disequilibrium by reducing the value of the domestic currency. Exchange rate depreciation reduces the value of home currency in relation to foreign currency. As a result, import becomes costlier and export become cheaper. Hence exchange rate will go down in case there is a deficit in the BoP.

The equilibrium exchange rate is where supply equas demand. if exchange rate is above the equilibrium rate then supply will be greater than demand and the other way round when exchange rate is below equilibrium. In either case the forces in the market adjust accordingly until equilibrium is restored and exchange rate comes down to equilibrium rate.So it doesn't matter if exchange rate goes above or below the equilibrium rate as it is adjusted in the long run to become equal to one another.

Supply and demand are the forces which drive the exchange rate back to equilibrium. if exchange rate is above equilibrium rate then supply greater than demand which will eventualy reduce the exchange rate while if exchange rate is below the equilibrium rate then demand is greater than supply which will eventually increase the exchange rate.

jeff jeffy answered 1 year ago

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