DETERMINATION OF FOREIGN EXCHANGE

FOREIGN EXCHANGE RATE It refers to the rate at which one currency is for the other.. 1$= Rs.40 Currency depreciation-it refers to decrease in the value of domestic currency. It means the domestic currency becomes less valuable, more of it is required to buy the foreign currency. Indian rupee is said to be depreciating if the price of dollar rises from rs.35 to rs.40 Currency appreciation refers to increase in the value of domestic currency in terms of foreign currency,i.e.,domestic currency becomes more valuable and less of it is required to buy the foreign currency. Indian rupee appreciates when price of 1 $ falls from rs.45 to 40.. There are 3 types of exchange rate systems:Fixed exchange rate system Flexible or floating exchange rate system Managed floating exchange rate system Fixed exchange rate systemit refers to the system in which rate of exchange for a currency is fixed by the govt. either in terms of gold or silver or in terms of any other countrys currency. The main purpose of adopting this system was to ensure stability in foreign trade and capital movements. Currency devaluationit refers to reduction in the value of domestic currency by the govt. Currency revaluationit refers to increase in the value of domestic currency by the govt. The diff. b/w currency dep. and currency devaluation is that in former case exchange rate is determined by the market and in the latter case the exchange rate is determined by the govt. Flexible exchange rate system it refers to a system in which the exchange rate is determined by the forces of demand and supply of different countries in the foreign exchange market. Managed floating exchange rate systemin this system foreign exchange is determined by the market forces and the central bank is a key participant to stabilize the currency in the case of extreme appreciation or dep. . . Hence its a hybrid of fixed and flexible exchange rate system. Determination of foreign exchange rate system:-

Exchange rate gets determined by the interaction of demand and supply of foreign exchange. Demand or outflow of foreign exchange arises due to the following reasons:Import of goods and services When Indian tourists go abroad/to undertake foreign tours by Indians. By making unilateral transfers For purchase of assets abroad For speculation purposes There exist an inverse relationship b/w demand for foreign exchange and its price. The demand curve is downward sloping. Supply or inflow of foreign exchange comes from following sources:Export of goods and services Tourists from abroad/foreign investments in India by foreigners. Unilateral transfers/reminders from abroad Speculation purposes There exist a direct relationship b/w supply of foreign currency and its price. Supply curve is upward sloping.

BALANCE OF PAYMENTS Its an accounting statement that provides a systematic record of all the economic transactions b/w the residents of a country and rest of the world in given period of time. Economic transactions are classified as:Visible goodsit includes physical goods which are exported & imported, such items are seen, touched & measured.

Invisible goodsthese refer to the services like shipping, banking, insurance.. Unilateral transfersthese include gifts, personal emmitances & other one way transactions Capital transfersthese relate to capital receipts through borrowing or sale of assets, through capital payment & purchase of assets. All inflows of foreign exchange are recorded on credit side & all outflows are recorded on debit side. Balance of payments is maintained on double entry book keeping system. Hence in accounting sense, credit & debit side has to be equal but in economic sense, balance of payment need not to be always equal. BALANCE OF TRADE It refers to the diff. b/w the amount of exports and imports of visible goods only. Exports are entered as credit or positive item whereas imports are always treated as debit or negative item. Balance of trade is a part of bal. of payments. Components of balance of payments All transactions entering the balance of payment are categorized into current a/c and capital a/c. Current a/cit refers to an a/c which records all the transactions relating to exports & imports of goods & services & unilateral transfers during a given period of time. Capital a/cit records all the transactions b/w the residents of a country & rest of the world which causes a change in the assets & liabilities of the residents of the country. Capital a/c includes:-Pvt. Transactions:--it includes short term & long term foreign loans. Receipts-Cr Repayment-Dr Official transactionsit includes transactions undertaken by the govt. with the rest of the world(borrowings from IMF, world bank etc.) Receipts-Cr Repayments-Dr Foreign direct investmentpurchase of assets in rest of the world such that it gives direct control to the purchase over asset acquisition foreign firm by an Indian firm. Port-folio investmentit refers to the purchase of any asset in the rest of the world in such a manner that it does not give the purchaser any direct control over the asset. Ex.purchase of shares of a foreign firm by a Indian firm AUTONOMOUS & ACCOMODATING ITEMS Autonomous items refers to those international economic transactions which take place due to some economic motive like profit maximization, such transactions are independent of the state of bal. of payment a/c. these items are also known as above the line items. Autonomous transactions take place on both current and capital a/cs., on the current a/c merchandised exports and imports of goods are

autonomous transactions whereas on the capital a/c, receipts & payments of long term loans by individuals are autonomous transactions. Accommodating items refers to the transactions that are undertaken in order to maintain the balance in bal. of payment a/c. These are compensating capital transactions which are meant to the disequilibrium in autonomous items of bal. of payments. These are also known as below the line items. If there is current a/c deficit, then the deficit is settled by capital inflow from abroad. Generally, the sources used to meet the deficit are foreign exchange reserves or borrowings from IMF etc. If there is disequilibrium in balance of payments, it leads to low economic credibility, decrease in foreign exchange reserves & low rate of economic development..