INDIAN SCHOOL BOUSHER

DEPARTMENT OF ECONOMICS
CHAPTER : FOREIGN EXCHANGE RATE

SL. QUESTION AND ANSWER

NO.
Q1. What is Foreign exchange rate?

 Foreign Exchange Rate refers to the rate at which one unit of foreign
currency can be interchanged for number of units in domestic currency.
 It is the price paid in domestic currency to change it to get one unit of
foreign currency
EG:- $1= ₹78 or $1 = ₹ 80

Q2. What are the sources of demand for foreign exchange?

OR
What is the need for foreign exchange?

1. To purchase goods and services from other countries.

2. To purchase assets(like land, shares, bond,etc.) in other countries.
3. For payment of international loans.
4. For the gifts and grants sent to the rest of the world.
5. Foreign exchange is needed to undertake foreign tours .

Q3. What are the sources of supply of foreign exchange?

OR

1. Export of products to foreign countries/the rest of the world.

2. Foreign direct investment (FDI).
3. Gift/ donation/ Remittance received from foreign country
Supply of foreign exchange also come when foreign tourists come to the
home/domestic country.

Q4. What are the types of Exchange rates? Explain in detail.

There are three types of exchange rates, which are as follows::

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 FIXED EXCHANGE RATE FLEXIBLE EXCHANGE RATE MANAGED FLOATING RATE
SYSTEM SYSTEM SYSTEM
Fixed exchange rate system is a - Flexible exchange rate Managed Floating exchange
rate of exchange which is fixed system is the rate which is rate is determined by the
by the government of the determined by the demand market forces of demand and
country or central bank and is and supply of different supply in international money
not dependent on the market currencies in the foreign market, BUT when the
forces exchange market. domestic currency is heavily
- It is a flexible rate because it depreciating the RBI
changes in accordance to the intervenes to place some
demand and supply of influence on the exchange rate
different currencies in the so that it remains with in its
foreign exchange market desired limits
It is also known as Pegged It is also known as Floating It is Also known as Dirty
exchange rate system . exchange rate system . Floating .
The exchange rate at which RBI sells foreign exchange in
demand for foreign currency is international money market.
equal to supply of foreign So that supply of foreign
currency is called Equilibrium exchange increases. Managed
rate or par rate of exchange. Floating is a hybrid of a fixed
and a flexible exchange rate
system
MERITS: MERITS:-
1. there is Stability in the 1. The equilibrium level of
exchange rate. demand and supply of
2. It promotes for international currency is determined .
investments. 2. There is no need of huge
3. Helps in prevention of gold reserve.
speculative activities. 3. It is a freemarket with no
4. It is not a free market . unwanted control of
government.
4. There is no problem of
undervaluation and
overvaluation .
DEMERITS:- DEMERITS:- :-
1. It needs huge amount of 1. Ttyyy
gold reserve. 2.
2. There is difficulty in fixing 3. Speculative activities
the exchange rate. 4. Creates inflationary `
3. There is Problem of 5. There is risk of foreign
Undervaluation and trade and foreign
Overvaluation of investments
Domestic currency.
Q5. What is the relation between Demand for foreign exchange and foreign
exchange rate? Explain with a diagram.

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 There is an inversely relationship between demand for foreign exchange and
foreign exchange rate.

The increase in Foreign exchange leads to decrease in demand for foreign

exchange and vice-versa.

Q6. What is the relation between supply of foreign exchange and foreign
exchange rate? Explain with a diagram.

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.

Q7. What is the difference between devaluation and depreciation.

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 BASIS DEVALUATION DEPRECIATION
Meaning It refers to fall in price ofIt refers to fall in price of
domestic currency under domestic currency under
fixed exchange rate system flexible exchange rate
Control It is under the control of It is under the control of
government market forces of demand and
supply
Exchange It deliberately done by It depends on value of trade,
rate system government to promote gold reserve, demand of the
exports and to bring domestic currency and as
foreign currency well as securities
Q8. What is the difference between Appreciation and depreciation of domestic
country?

Appreciation of Depreciation of
domestic currency domestic currency
It refers to increase in the value of It refers to decrease in the value of
domestic currency in terms of domestic currency in terms of
foreign currency. foreign currency
EG:- EG:-
$1 = ₹80 (old stage) $1= ₹70 (Old stage)
$1 = ₹70 (new stage) $1= ₹80 (new stage)
In old stage , ₹80 is required to buy In above example, old stage ₹70 is
one US dollar and in new stage, to required to buy one US dollar and
buy on US dollar we have to pay in new stage to buy one US dollar
₹70. This shows that domestic we have to pay ₹80. This domestic
currency become more valuable. currency become less valuable.

Q9. What are the reasons behind Depreciation of domestic currency?

The two reasons behind depreciation of domestic currency are as follows:

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 1.
a) Increase in demand for foreign currency leads to rise in foreign
exchange rate
b) In the given diagram as demand increases from DD to D1D1, then
exchange rate increases from OR to OR1.

2. Decrease in supply of foreign currency:

a) A decrease in supply of foreign exchange leads to rise in foreign
exchange rate.
b) In the given diagram as supply decreases from SS to S1S1, then
exchange rate increases from OR to OR1.

What are the causes of Appreciation of domestic Currency?

Q10.
There are two reasons behind the appreciation of domestic country:

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 1.
A) Increase in supply of foreign currency leads to fall in FOREX rate.

B) In the given diagram, supply rises from SS to S1S1 , Then the

exchange rate decreases from OR to OR1.

1.
A) fall in demand of foreign exchange leads to decrease in foreign
exchange rate.

B) In the given diagram, demand falls from DD to D1D1, which leads

exchange rate decreases from OR to OR1.

Q11. Explain in detail about the functions of Foreign Exchange market.

The functions of foreign exchange market are as follows:

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 IPH – I Play Hockey
a) International transfer of foreign currency:
 Foreign exchange of market helps in transferring foreign currency
from one country to another, when and where it is needed.
b) Provide credit for foreign trade:
 Foreign exchange market provides credit for foreign trade.
c) Hedging foreign exchange risk:
 Hedging means covering exchange risk.
 It is done by foreign exchange rate in forward transactions through
the banks. Foreign exchange market makes a contract to buy or sell
foreign exchange in advance to pay future date at predetermined
price.
Q12. Differentiate between Spot Market and Forward market.

SPOT MARKET FORWARD MARKET

It is the market which handles only It is the market which handles such
spot/short term/current transaction. transactions of foreign exchange,
which are meant for future delivery.
It deals in daily nature transactions. It does not deal in spot transactions.
The rate of exchange which is It determines a rate of exchange for
determined in the spot market is future called forward exchange rate.
known as spot rate of exchange.

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