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By the end of this topic, you should be able to:
The exchange rate is the price of one country's currency expressed in terms of another country's currency. In other words, it tells you how much of one currency you need to buy a unit of another currency.
Example: If the exchange rate between Pakistan and the USA is 1 USD = 280 PKR, then one US dollar can buy 280 Pakistani rupees.
Think of it this way: just like a product has a price in a shop, a currency has a "price" too — and that price is the exchange rate.
The exchange rate represents the external value of a currency — how much it is worth compared to other currencies in the world.
A floating exchange rate is one where the value of a currency is determined entirely by market forces — that is, by the demand for and supply of that currency in the foreign exchange market. The government does not interfere to set or fix the rate.
This works just like any other market. Think of the currency as a product:
The demand for a currency comes from foreigners who want to buy that country's goods, services, or assets. They need to exchange their own currency for the local currency.
The demand curve slopes downward — this means when the exchange rate is high (the currency is expensive), fewer foreigners want to buy it, so quantity demanded is lower.
The supply of a currency comes from locals who want to buy foreign goods, invest abroad, or travel. To do this, they sell (supply) their own currency in exchange for foreign currency.
The supply curve slopes upward — when the exchange rate is high, locals find it cheap to buy foreign currency, so they supply more of their own currency.
Just like in any supply and demand diagram, the equilibrium exchange rate is found where the demand curve and the supply curve intersect. At this point, the quantity of currency demanded equals the quantity supplied.
📊 Diagram to Know: Draw a standard demand and supply graph. Label the vertical axis "Exchange Rate (ER)" and the horizontal axis "Quantity of Currency." The downward-sloping curve is Demand (D) and the upward-sloping curve is Supply (S). Where they cross is the equilibrium exchange rate.
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