Question

Explain how a free and competitive market for the exchange rate between two countries ensures that the whole macro economy is in equilibrium.

Answer 1

Answer - The free and fair markets leads to the proper interaction between the demand and supply of foreign exchange without the occurance of any inefficiency.

If due to lower exchange rate , the demand for a currency rises , the demand curve will shift right. This will lead to the rise in the exchange rate and with rise in exchange rate , supply of currency will rise. Hence rise in demand and exchange rate is compensated through autotmatic rise in supply.

In the same way , increased exchange rate will lead to rise in supply of currency. This will lead to lower exchange rate. Now , with low exchange rate , demand will rise and exchange rate will shift up to come to equilibrium again.

Hence this shows that if the markets are free and efficient , they will ensure that the markets in the economy are in equilibrium, whether it is goods market or currency market.