FOREIGN EXCHANGE & FOREIGN EXCHANGE RATE
Foreign exchange refers to foreign currency.
It refers to the stock of all foreign currencies with the RBI at a point of time.
$ is the most valuable currency in the world so usually the entire stock of all the
currencies is converted and measured in terms of US $.
Foreign exchange rate: The rate at which domestic currency can be exchanged for a
foreign currency. Also called 'external value of the domestic currency'.
Eg: At present approx. ₹ 80 are required to be paid to buy one USD which means the
exchange rate is: $1: ₹ 80
Classification of EXCHANGE RATE
(I) Flexible or floating rate of exchange: Also called as free exchange rate.
It is determined by the supply-demand forces in the foreign exchange market.
Par Rate or Equilibrium Rate of Exchange: The exchange rate at which demand for
foreign currency is equal to its supply is called
Determination of Flexible Exchange Rate
a. Demand for Foreign Exchange is inversely related to the price of foreign exchange
i.e. if rate of forex is demand or if rate of forex is demand
b. Supply of Foreign Exchange is positively related to the rate of foreign exchange
i.e. if rate of forex is demand or if rate of forex is demand
Equilibrium or Par Rate of Exchange
It occurs when: supply of foreign exchange = demand for foreign exchange.
Diagrammatically, equilibrium rate of exchange corresponds to point where supply
and demand curves in the foreign exchange market intersect each other.
Impact of Change in Demand and Supply
Situation 1: Impact of Increase in Demand for a Foreign Currency (US$):
Depreciation of Domestic Currency
Increase in demand is reflected by a shift in demand curve to the right.
Currency depreciation refers to a situation when domestic currency ₹ () or loses
its value in relation to a foreign currency like US $.
Eg: If US $ exchanges for 85, instead of 80 earlier, the ₹ shows depreciation.
Situation 2: Impact of Decrease in Demand for a Foreign Currency (US $):
Appreciation of Domestic Currency
Decrease in demand is reflected by a shift in demand curve to the left.
Currency appreciation refers to a situation when domestic currency ₹ () or gains
its value in relation to a foreign currency.
Eg: If US $ exchanges for 75, instead of 80 earlier, the ₹ shows appreciation.
Situation 3: Impact of Increase in Supply of Foreign Currency (US $):
Appreciation of Domestic Currency
Increase in supply is reflected by a shift in supply curve to the right.
Situation 4: Impact of Decrease in Supply of Foreign Currency {US $):
Depreciation of Domestic Currency
Decrease in supply is reflected by a shift in supply curve to the left.
To sum up all above we can say that
Depreciation: Exchange rate () when Demand () or Supply () of foreign
currency.
Appreciation: Exchange rate () when Demand () or Supply () of foreign
currency.
(II) Fixed Exchange Rate is set and maintained by the government at a particular
level. The government may set it at a level higher or lower than the equilibrium
exchange rate as determined by the market forces of supply and demand.
When Exchange Rate is set higher than the Equilibrium Exchange Rate
Government will deliberately lower the value of the domestic currency i.e. ₹. This is
called 'devaluation'. The market forces of supply and demand play no role
whatsoever.
Devaluation is different from ‘depreciation’ which means decline in value of ₹ in
the international money market, because of the market forces of supply and demand.
The government plays no role whatsoever.
When Exchange Rate is set lower than the Equilibrium Exchange Rate
Government deliberately raise the value of ₹ which is called 'Revaluation’. The
market forces of supply and demand play no role whatsoever.
Revaluation of the currency is different from Appreciation of the currency which
means rise in the value of ₹ in the international money market, because of the market
forces of supply and demand. The government plays no
role whatsoever.
***Less Developed Countries often Devalue their Currency i.e. domestic currency
is made cheaper in relation to the foreign currency because of the following reasons:
Devaluation i.e. in the value of the domestic currency is expected to demand
for the domestically produced goods and services. Accordingly, exports
Exports is expected to the supply of foreign exchange into the domestic
economy. This facilitates import of essential goods from rest of the world.
in domestic currency induces private foreign investment because, for
every dollar, the investors are going to get more of domestic currency which is
expected to promote GDP growth
Gold Standard System of Exchange Rate- An Old Variant of Fixed Exchange Rate
System
According to this system, gold was taken as the common unit of parity between
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 £ = 1 Gram of gold and 1 ₹ 0.01 gram of gold, then 1 £ = ₹ 100. This system of
exchange was also known as Mint Par Value of Exchange or Mint Parity. Mint value
of a currency implied gold value of that currency.
Bretton Woods System of Exchange Rate Or Adjustable Peg System of Exchange
Rate
This system allowed some adjustments, so, it was called 'adjustable peg system of
exchange rate'. According to this system,
(i) Different currencies were pegged (or related) to one currency, that is US dollar.
(ii) US dollar was assigned gold value at a fixed price
(iii) Value of one currency in terms of US dollar ultimately implied value of that
currency in terms of gold.
(iv) Gold continued to be the ultimate unit of parity between any two currencies.
(v) Adjustment in the parity value of a currency was possible but only if allowed by
IMF{International Monetary Fund).
Even this system was abandoned in 1977. It was replaced by a flexible
system of exchange rate.
Difference between the fixed and flexible exchange rates
Basis Fixed Rate Flexible Exchange Rate
Definition Fixed rate is the system where Flexible exchange rate is the
the government decides the system which is dependent on
exchange rate the demand and supply of the
currency in the market
Deciding Central government Demand and Supply forces
authority
Impact on Currency is devalued and if Currency appreciates and
Currency any changes take place in the depreciates in a flexible
currency, it is revalued. exchange rate
Involvement Government bank determines No such involvement of
of the rate of exchange government bank
Government
Bank
Need for Foreign reserves need to be No need for maintaining
maintaining maintained foreign reserve
foreign
reserve
Impact on Can cause deficit in BOP that Deficit or surplus in BOP is
BOP cannot be adjusted automatically corrected
(Balance of
Payment)
Managed floating
is a tool employed by the central bank to restore the value of the country's
currency (in relation to other currencies) within the desired limits, even when
exchange rate is determined by the market forces of demand and supply.
In fact, managed floating may be called as the mixture of both flexible and
fixed exchange rate systems. It comprises the element of flexible exchange rate
system as the exchange rate is primarily determined by the forces of supply
and demand. Likewise, it comprises the element of fixed exchange rate system
as the exchange rate is moderated (or managed) by way of intervention by the
RBI.
Sources of demand of foreign exchange or why is foreign exchange
demanded
The demand (or outflow) of foreign exchange comes from the people who
need it to make payments in foreign currencies. It is demanded by the domestic
residents for the following reasons:
Imports of Goods and Services: When India imports goods and
services, foreign exchange is demanded to make the payment for imports
of goods and services.
Tourism: Foreign exchange is demanded to meet expenditure incurred
in foreign tours.
Unilateral Transfers Sent Abroad: Foreign exchange is required for
making unilateral transfers like sending gifts to other countries.
Purchase of Assets in Foreign Countries: It is demanded to make
payment for purchase of assets, like land, shares, bonds, etc. in foreign
countries.
Repayment of loans to Foreigners: As and when we have to pay
interest and repay the loans to foreign lenders, we require foreign
exchange.
Speculation: Demand for foreign exchange arises when people want to
make gains from appreciation of currency
Sources of supply of foreign exchange
The supply (inflow) of foreign exchange comes from the people who receive it
due to the following reasons.
Exports of Goods and Services: Supply of foreign exchange comes
through exports of goods and services.
Tourism: The amount, which foreigners spend in the home country,
increases the supply of foreign exchange.
Remittances (unilateral transfers) from Abroad: Supply of foreign
exchange increases in the form of gifts and other remittances from
abroad.
Loan from Rest of the world: It refers to borrowing from abroad. A
loan from U.S. means flow of U.S. $ from U.S. to India, which will
increase supply of Foreign exchange.
Foreign Investment: The amount, which foreigners invest in our home
country, increases the supply of foreign exchange.
Speculation: Supply of foreign exchange comes from those who want to
speculate on the value of foreign exchange.
Foreign exchange market
is the market where the national currencies are converted, exchanged or traded
for one another.
Functions of a foreign exchange market
Transfer Function: Transfer function refers to transferring of
purchasing power among countries.
Credit Function: It implies provision of credit in terms of foreign
exchange for the export and import of goods and services across
different countries of the world.
Hedging Function: Hedging function pertains to protecting against
foreign exchange risks. Where Hedging is an activity which is designed
to minimize the risk of loss.
Kinds Of Foreign Exchange Rate (Spot And Forward Market)
1. Spot market for foreign exchange
If the operation is of daily nature, it is called spot market or current market.
The exchange rate that prevails in the spots market for foreign exchange is called
spot rate.
In other words, spot rate of exchange refers to the rate at which foreign currency is
available on the spot.
2. Forward market for foreign exchange
A market for foreign exchange for future delivery is known as forward market.
Exchange rate that prevails in a forward contract for purchase or sale of foreign
exchange is called forward rate.
Thus, forward rate is the rate at which a future contract for foreign currency is
bought and sold.
