Demand for foreign exchange:
⇒The exchange rate in a free market or in flexible exchange rate system is determined by the demand for and supply of foreign exchange. The equilibrium exchange rate is the rate at which the demand for foreign exchange equals to supply of foreign exchange.
1. The India individuals, firms or government who import goods from the USA into India.
2. The Indians travelling and studying in the USA would require dollars to meet their expenses.
3. The Indians who want to invest in equality shares and bounds of the U.S. companies.
4. The Indians firms who want to invest directly in building factories, shops in the USA There is an inverse relationship between demand for foreign exchange and rate of exchange. When there is a fall in the price of dollar i.e. when the dollar depreciates fewer rupees than before would be required to get a dollar. This will induce Indian individuals and firms to import more from the USA resulting in the increase in quantity demanded of dollars by the Indian.
On the other hand if the price of US dollar rises i.e. US dollar appreciate more rupee than before would be required to get a dollar. This will discourage the imports of US goods of India, causing a decrease in quantity demanded of dollars for imports.
This inverse relation makes the demand curve for dollar downward sloping as shown by the DD1 curve in figure