UNIT-5

foreign Exchange

- Foreign exchange rate

The foreign exchange rate is the rate at which one currency is exchange for another. "It is the prize of
one co currency in terms of the other generally every country thas its own "currency which is accepted
within the boundary of that country but the same would not be accepted. any other country. Therefore
trade of lu nations is only possible exchanges of one country for that of other.

 The exchange rate is also known as rate of exchange b/w countries.

 The exchange rate in free market is determined by demand for & supply of foreign currency.
 Exchange rates are imp. b/w they influence the balance of trade e balance of payment of
country.
 Increase in trade & globalisation has lead to further increase in subject matter of foreign.
Exchange
 There are broadly 3 types of exchange rate systems.

1. fix exchange rate

2. flexible exchange rate
3. managed floating exchange rate.

→ Determination of Foreign Exchange Rate..

 exchange rates in free market economy our the flexible regime is determined interaction b/w
the forces of demand & supply of foreign currency.

 The demand four foreign exchange might arise due to various economic activities like purchase
of goods & services from other countries, gives grants, loans to from foreign countries. to invest
in other countries, to make payments of international loans etc.
 There is an inverse relations b/w foreign exchange. rate and demand for foreign exchange rate.

 Higher the foreign exchange rate lower us demand four foreign include lower the foreign
exchange rate higher is demand four foreign exchange.
 supply of foreign currency comes from experts, foreign investment, remetences from abroad.
 suppose the price of us dollar in India falls from to 70 to Rs 6o at means that earlier Indian people
had to pay rs 70 buy 1 dollar worth of foods from USA! but now they have to pay 60rs to buy 1
dollar worth of goods this means from Indian perspective American "goods have become cheaper.

At a lower price of us dollar India is ready to buy more goods from USA. This raises the demand for
us dollar so lower was the price of us dollars higher is demand for is dollars & vice versa.

→ supply of foreign Exchange

 There is direct relation b/w foreign exchange rate and supply of foreign exchange.
 Higher the exchange rate higher is supply of foreign exchange" as follow lower.

Let's consider that the price of US dollar in India falls from Rs. 70 to Rs. 60. It means that - earlier
USA could buy 70 rs worth of good in India by giving 1$ but now it can buy 60 rs of good from India.

Indian goods have become costlier comparatively of Indian goods this reduces the supply of us
dollar to India Hence there is direct relation blw exchange rate and the supply of foreign exchange.

→ Determination of Equilibrium exchange rate

In a Flexible exchange rate regime the exchange is determined at a point where demand & supply of
of foreign exchange intersect each other. It is also knows as equilibrium point.

 Types of Exchange Rate system.

1. Fix Exchange Rate system:-

Fix rate of exchange is exchange rate which is Offically declared and fixed by govt.

In it there are two variants –

a) Gold standard system of exchange rate.

b) Bretton woods system.

• Fix exchange rate system is also known as legged exchange rate

• Under the system the exchange rate fixed for particular period of time & not forever.

• Under this system the countries's central bank is involved in buying & selling of currency in order to
hold exchange rate at particular level.

when there is excess supply on foreign exchange the central bank may buy foreign currency & it. may
sell the currency.

The exchange rate might the fixed either by legislation our intervention in the currency market.
The national currency would be made to appreciate our depreciate acc to need of country.

→Merits of Fix Exchange Rate system –

o Stability in exchange rate, benefiting the exporters and importers.
o encourages long term capital flows.
o No fear of people in currency fluctuation, confidence of people in domestic currency increases.
o Prevents speculation
o Holding Prevented.
o Disciplinary, acc to need of country.
o Might benefit smaller countries..
o Encourages multilateral trades.

- Demerits of Freed Exchange Rate

 Contradict free market economy.
 Unexpected results if exchange rate faces deliver.
 Heavy burden to keep foreign exchange reserve.
 Complex system requiring specialist & statically analysis.
 Not always possible to keep exchange rate du to constant changes in Economy.
 It might make country dependent on inter national institution for boveourin time of crises.
 Constant pressure go under value our over value domestic currency lance of payment.

→ Flexible Exchange Rate .

It is rate which is determined by demand & supply of foreign country in the foreign exchange market.

The monetary authority or govt. must not infixing exchange rate. It is also known as floating exchange.

Exchange rate keeps fluctuating if there is excess supply of currency compare to its demand. The value
of currency in foreign exchange market will fall. On the other hand shortage of currency compare to its
demand would lead increase in its value & appreciation of its rate.

→ Merits of Flexible rechange Rate

o Based on free market, govt. is free on manage the exchange rate.
o Eliminates the problem of over valuation & under Valuation of currency.
o Balance of payment automatically be corrected.
o No need to hold any foreign exchange reserves.
o simple in operation.
o Promotes international trades b/w countries. Following flexible exchange rate system.
o Removes the problem of international liquidity Shortage.

It is economical not requiring much statistical statistica

 Dements of Flexible exchange Rate.

By fluctuation in exchange rate due to instability & uncertainty.
 fluctuation affect foreign trade & capital moments adversly.

The less developed country might continuously. pace the problem of balance of payment deficit.

Countious fluctuation might hamper domestic development policies.

large inflows & outflows capital due to content fluctuation and speculation.

2. Managed floating :- most commonaly used exchange rate system presently Also known as
Hybrid systems.

Might be combination of flexible and fixed exchange rate.

In this system central authority intervene, in free market mechanism only if it feat necessary.

There is no fixed time frame, fixed exchange rate our official declaration for same.

This system is used so that country's developmental policies are not compromised due to wide
fluctuation in foreign exchange market.

Intervention is in the form of buying g selling market of currency in foreign. In order to suit domestic
need.

Sometimes it is also called as dirty floating when a particular country manipulates, its managed float to
disadvantage of other countries.

→ Foreign Exchange Market Foreign exchange

Foreign exchange market is market there foreign currencies are bought & sold.

It is not physical market but it operates transaction take place through which transaction take place
electronically.

The foreign exchange market facilities buying and selling the orders and goods across border.

Commercial banks, brokers, exportes, importes tourists, immigrants, investors, are Players of foreign
exchange market.

There are large number of foreign Currencies that are traded.

These transactions are dynamic in nature Which keep changing continuously.

Central Banks, Multinational Corporation are major players.

 Functions of foreign Exchange market:

1) Transfer function – The foreign goods from “market helps in transfer exchange one country to other.
It facilitates funds to settle payments needed by traders, bank breakers etc.

2)Credit function: A foreign exchange market serves as short term facilities to traders, - banks, govt etc
to carry on uninterrupted Foreign trade & transaction.
3) Hadging Function - Hadging meant t covering up and exchange rate risk because fluctuations in the
foreign exchange rate market there can be sudden booses and hence hadging is used as an action. It is a
contract b/w various a agents that is "done in advance to avoid risk in future.

→ Balance of Trade-(BOT) - Balance of Trade shows visible trade transaction of the country with rest
of world during a year it refers to difference in the value of exported & imported.

It is a narrow concept which give a partial view of the country's economic status.

Favourable balance of trade is when the total value of goods exported by the country exchange the total
value of goods imported by it. It is also called

Unfavourable BOT is when total value of goods imported is move than the total value of good exported
in country. It is also called deficit Bot..

There could also equilibrium BOT if the value of export & import equal.

→ Balance of payments-
BOP is a systematic record of a countries external economic transaction with the rest of world over a
period of one year.

It is an account maintaining a statistical record of a residence of country with respect to payments. And
receipt.

It includes the receipt that the residence of the country get by selling of goods & services, capital
transfer etc.

It also includes the payment that the residence of make an account of goods and services and transfer
of capital from these countries to the rest of world.

It is a systematic record based on double entry book keeping system.

Each transaction is recorded on credit and debit side on the balance sheet.

The Principle stems on credit side are exports of goods & services, transfers receives in form of gifts and
grant from foreignere, borrowing from investment by foreigner in the country etc.

The Principle item on debit side include imports of goods and services, lending foreign countries,
investment etc.

Thus in pimple terms any transaction that brings in foreign exchange of country is credit stem
transaction that catives to loose its fourry, exeling is debit stem.

Thus balance of payment is movie inclusive concept that gives clear picture of country's economy as it
includes all & such transactions.

• The balance of payment account is divided into two:

a. Current Account.
b. Capital Account.
1) Current Account:- Includes transaction related to exchange of goods & services, unilateral transfers
(donations, grants etc.), Investment income profits & dividends) etc. Current Account transaction bring
out a change in the current level of country's income

2) Capital Account:- Records transactions related to capital transfers such as loans, invest thus
transaction capital account bring about change in assets & liabilities of nation.

→Disequilibrium – Imbalance of paymentent –

BOP is said to be disequilibrium when there is deficit as surplus of a large magnitude which carries on
over years.

In real terms BOP is always in disequilibrium.

We give more importance to disequilibrium in Bot when there is deficit.

A Continuous deficit in BOP hampers economic development, reduces foreign exchange rapidly.

The Credibility of country is affected and Leads to the economic subjugation.

→ Causes of Disequilibrium in BOP-

Fundamental disequilibrium – It is persistent long run disequilibrium which is caused due to changes in
consumers taste within the country or abroad which affects import & export of country.

It is also due to continuous fall in the country’s Foreign exchange reserves. Another cause might be
excessive capital inflows and out flows.

1) Inflation:- Due to demand for higher prices of raw material might make exports. Costlier adversly
affecting Bop.

2) structural Disequilibrium:- This disequilibrium Is caused due to changes in the method of production,
long term import-export restriction, deficiency of particular resource etc.

3) Cyclical Disequilibrium:- Business cycle fluctuation also effect BOP.

Exports and imports are affected due to different phases of business cycle.

4) Other Causes :-Temporary changes due to seasonal fluctuation random variations in trade that occur
In a short time also affect BOP figures

• The BOP figure also depends upon stage of economic development of the country. An under
developed our developing country needs to important machinery whearas its export would be primary
products.

• Changes in foreign exchange rate, domestic over-valuation of domestic currency also affect BOP
population explosion also affect the export- import pattern ultimately affecting the BOP figure.

social factors like demonstration effect, religions cultural factors might also affect "BOP in short term
political factors like instability, war, portion, unification of country also affect BOP figure.