Determination of Exchange Rate

Exchange rate is determined using the demand-supply approach of foreign exchange, also called the BOP theory of foreign exchange. Since the foreign exchange rate is a price, economists apply supply-demand conditions of price theory in the foreign exchange market.

Demand for Foreign Exchange:

When Nigerian people and business firms want to make payments to the US nationals for buying US goods and services or to send gifts or buy assets there, the demand for foreign exchange (dollars) is generated. In other words, Nigerians demand for or buy dollars by paying naira in the foreign exchange market.

A country releases its foreign currency for buying imports. Thus, what will appear on the debit side of the BOP account are the sources of demand for foreign exchange. The larger the volume of imports; the greater is the demand for foreign exchange.

Supply of Foreign Exchange:

Supply of foreign currency comes from the receipts for a country’s exports. If the foreign nationals and firms intend to purchase Nigerian goods or buy Nigerian assets or give grants to the Nigerian government, the supply of foreign exchange is generated.

In other words, what Nigeria exports (both goods and services) to the rest of the world is the source of supply of foreign exchange. All the transactions that will appear on the credit side of the BOP account are the sources of supply of foreign exchange. The greater the volume of exports; the greater is the supply of foreign exchange.