Foreign Exchange Rate 6

Foreign exchange rate refers to the rate at which one unit of foreign currency
can be exchanged for number of units in domestic currency.
OR It is the price paid in domestic currency in order to get one unit of
foreign currency.
1
e.g. $1 = `75 or `1 = $
75
There are two types of exchange rate
1. Fixed exchange rate system
2. Flexible (or) floating exchange rate system
1. Fixed exchange rate system
Fixed exchange rate system is a rate of exchange which is fixed by government.
Historically, it has two important variables:
(a) Gold standard system (1870 - 1914)
(b) Bretton woods system of exchange
(a) Gold standard system exchange: According to this sytem before 1920’s
gold was taken as common unit of exchange between the currencies of different
countries.
Each country was to define value of its currency in terms of gold. Accordingly
value of one currency in terms of the other currency was fixed considering gold
value of each currency.
eg. 1 UK £ = 4 gm gold, 1 US $ = 2 gm gold
then 1 UK £ = 2 US $ (exchange ratio between UK and US)
This system is also known as mint par value of exchange or mint parity.
(b) Bretton woods system of exchange (1944 - 1971): According to this
system US $ was taken as common unit of exchange between the currency of
different countries.
Different currencies are related to one currency i.e. US $ (dollar).
Each country was to define value of its currency in terms of US Dollar.
It is also called Adjustable peg system of exchange.
2. Flexible (or) floating exchange rate system
It is the rate which is determined by the demand for and supply of different
currencies in the foreign exchange market.
In other words, flexible exchange rate is determined by the market forces.
The exchange rate at which demand for foreign currency is equal to supply of
foreign currency is called equilibrium rate or normal rate or par rate of exchange.
It is a flexible rate because it tends to change in accordance with changes in
the demand and supply for different currencies in the foreign exchange market.

(68)
FOREIGN EXCHANGE RATE 69

* DEMAND FOR FOREIGN EXCHANGE

(OR)  Why foreign exchange is Demanded
(OR)  What are the sources of demand for foreign exchange?
Ans.(i) To purchase goods and services from other countries.
(ii) To purchase assets (like land, shares, bond, etc.) in other countries.
(iii) Payment of international loans.
(iv) Gift and grants sent to rest of the world.
(v) Foreign exchange is needed to undertake
foreign tours.
There is an inverse relationship between Demand
for foreign exchange and foreign exchange rate.
Increase in foreign exchange rate leads to
decrease in demand for foreign exchange and
vice-versa.
*  SUPPLY FOR FOREIGN EXCHANGE
(OR)  Why foreign exchange is Supplied?
(OR)  What are the sources of supply of foreign exchange?
Ans. (i) Export of the country to rest of the world.
(ii) Foreign direct investment (FDI).
(iii) Gift / donation / Remitance received
from foreign countries.
(iv) Supply of foreign exchange also comes
when foreign tourists come in to Home
Country.
There is a Direct relationship between supply
of foreign exchange and foreign exchange rate.
Increase in foreign exchange rate leads
to increase in supply of foreign exchange and
vice-versa.
Equilibrium Rate of Exchange
It is the rate at which demand for foreign
exchange and supply of foreign exchange are equal.
In the given diagram, X axis represents
demand and supply of foreign exchange and Y
axis represents foreign exchange rate.
‘DD’ shows Demand Curve of foreign
exchange and curve ‘SS’ shows Supply of foreign
exchange.
Point ‘e’ stands for equilibrium point where
Demand ‘DD’ is equal to supply SS. OR is the
equilibrium rate of exchange and OQ is the
equilibrium quantity.
70 MACRO ECONOMICS

Depreciation of Domestic Currency

(Or)
Appreciation of Foreign Currency
It refers to decrease in the value of domestic currency in terms of foreign
currency. Here Domestic Currency is less valuable.
e.g. $1 = ` 50 (Old stage)
$1 = ` 70 (New stage)
In the above example Indian rupee is less valuable. In old stage ` 50 is
required to buy one US dollar and in new stage to buy one US dollar we have to
pay ` 70. This shows that domestic currency is less valuable.
There are two reasons behind depreciation of domestic currency.
(i) Increase in demand for foreign
currency.
An increase in demand for foreign
exchange leads to raise in foreign exchange
rate.
In the given diagram as Demand
increases from DD to D′D′ then exchange
rate increases from OR to OR′.

(ii) Decrease in supply of foreign currency.

A decrease in supply of foreign exchange
leads to raise in foreign exchange rate.
In the given diagram as supply decreases
from SS to S′S′ then exchange rate increases
from OR to OR′.

Effects of Depreciation of Domestic Currency on Exports

Depreciation of domestic currency means a fall in the price of domestic
currency (say rupee) in terms of a foreign currency (say US dollar). It means one
dollar can be exchanged for more rupee. So with the same amount of dollar more
goods can be purchased from India. It means export to USA becomes cheaper.
This may result an increase of Indian export to USA.
FOREIGN EXCHANGE RATE 71

Effects of Depreciation of Domestic Currency on Imports

Depreciation of domestic currency means fall in the price of domestic
currency (say rupee) in terms of a foreign currency (say US dollar). It means one
dollar can be exchange for more rupee so with the same amount of rupee less
goods can be puchased from USA. It means import from USA is expensive. This
may results decrease in imports from USA.
Appreciation of Domestic Currency
    (OR)
Depreciation of Foreign Currency
It refers to increase in the value of domestic currency in terms of foreign
currency.
e.g. $ 1 = ` 70 (old stage)
$ 1 = ` 60 (new stage)
In the above example, Indian rupee is more valuable in old stage `70 is
required to buy one US dollar and in new stage to buy one US dollar we have to
pay only `60. This shows that domestic currency is more valuable.
There are two reasons behind appreciation of domestic currency.
(i) Increase in supply of foreign currency.
An increase in supply of foreign exchange
leads to fall in foreign exchange rate.
In the given diagram as supply increases
from SS to S′S′ then exchange rate decreases
from OR to OR′.

(ii) Decrease in Demand for foreign currency.

A decrease in demand of foreign exchange
leads to fall in foreign exchange rate.
In the given diagram as Demand decrease
from DD to D′D′ then exchange rate decreases
from OR to OR′.
72 MACRO ECONOMICS

Effects of Appreciation of Domestic Currency on Exports

Appreciation of domestic currency means a fall in price of foreign currency
(Say US dollar) in terms of domestic currency (say rupee).
It means foreigners have to spend more for purchase goods from India.
So with the same amount of dollar less goods can be purchased from India.
It means export to USA becomes expensive. This may result a decrease of Indian
export to USA.
Effects of Appreciation of Domestic Currency on Imports
Appreciation of domestic currency means a fall in price of foreign currency
(say US dollar) in terms of domestic currency (say rupee).
It means Indians have to spend less for purchase goods from abroad.
So with the same amount of rupee more goods can be purchased from
abroad. It means import from USA becomes cheaper. This may result an increase
in Indian imports from USA.
Managed Floating
It is a system in which exchange rate is determined by the market forces of
demand and supply in international money market, but when domestic currency
is heavily depreciating then Reserve Bank of India intervences to place some
influence on the exchange rate so that it remains with in the desired limits.
It is also known as ‘Dirty floating’. Here RBI sells foreign exchange in
international money market. So that supply of foreign exchange increases
managed floating is a hybrid of a fixed exchange rate and a flexible exchange
rate system.
Difference between Devaluation and Depreciation of domestic currency.
Basis Devaluation Depreciation
1. Meaning It refers to fall in price of
It refers to fall in price of
domestic currency underdomestic currency under
fixed exchange rate flexible exchange rate
system. system.
2. Control It is under the control of
It is under the control of
Government. market forces of demand
and supply.
3. Exchange rate It was in fixed exchange It is in flexible exchange
system rate system. rate system.

FOREIGN EXCHANGE MARKET

It is a market for foreign currencies i.e. here foreign currencies are purchases
and sold.
Functions of foreign exchange market.
(i) International transfer of foreign currency: Foreign exchange market
helps in transferring foreign currency from one country to another where it is
needed.
FOREIGN EXCHANGE RATE 73

(ii) Provide credit for foreign trade: Foreign exchange market provides
credit for foreign trade.
(iii) Hedging foreign exchange risk: Hedging means covering exchange
risk. It is done by foreign exchange rate in forward transactions through banks.
Foreign exchange market makes a contract to buy or sell foreign exchange in
advance to pay in future date at predetermined price.
Types of Foreign Exchange Market
(i) Spot Market
(ii) Forward Market
(i) Spot Market (Current market): It is that market which handles only
spot/current transactions. It operates daily nature transactions.
The rate of exchange which is determined in the spot market is known as
spot rate of exchange.
(ii) Forward Market: It is that market which handles such transactions of
foreign exchange which are meant for future delivery. It does not deal in spot
transactions.
It determines a rate of exchange for future called forward exchange rate.

IMPORTANT QUESTONS
Q1. In the following cases, identify which currency is appreciating and which
is depreciating.
(i) A change from 2$ = `50 to 1$ = `30
(ii) A change from 3Y _ = 2£ to 1£ = 1Y_
(iii) A change from 5 =C = 4£ to 2 C = = 3£
Q2. Define managed floating.
Q3. Why foreign exchange is demanded?
Q4. Differentiate between devaluatiion and depreciation.
Q5. What are the sources of supply of foreign exchange?
Q6. Answer the following:
(i) Explain the effect of rise in price of foreign currency on exports.
(ii) Explain the effect of depreciation of domestic currency on imports.
(iii) Explain the effect of depreciation of foreign currency on exports.
(iv) Explain the effect of fall in price of foreign currency on imports.
Q7. What are the functions of foreign exchange market?
Q8. Define equilibrium rate of exchange and how it is determined?
Q9. Differentiate between
(i) Spot market and forward market
(ii) fixed exchange rate and flexible exchange rate.
Q10. Show the relationship of foreign exchange rate with demand for foreign
exchange and supply of foreign exchange. Use diagram.
74 MACRO ECONOMICS

IMPORTANT NOTES