Foreign exchange rate (Macro)
Meaning of foreign exchange rate
Foreign exchange rate is the rate at which one currency can be converted into another currency.
Or
The rate of exchange measures the number of units of one currency which is exchanged in the
foreign market for one unit of another currency.
Determination of foreign exchange rate
There are two ways to decide the conversion rate between currencies:-
a) Fixed exchange rate: -It refers to rate of exchange as fixed by the government such a rate
does not vary with change in demand and supply of foreign currency. Only government has the
power to change it.
b) Floating (flexible) exchange rate – It is that rate which is determined by the demand and
supply of different currencies in the foreign exchange market. In other words, it is determined by
the market forces, like the price of any other commodity.
Note:-i) Managed floating rate-
It is a system that allows adjustments in exchange rate according to a set of rules and regulations
which are officially declared in the foreign exchange market.
Or
It is a system in which the central bank tries to influence the exchange rate by entering the
market as a bulk buyer or seller .When the central bank finds the floating rate too high, it starts
selling foreign exchange from its reserve to bring down the rate when it find finds the rate too
low, it starts buying to raise the rate.
ii) Dirty floating:-It refers to a situation when ‘managed floating’ is exercised without caring for
the rule and regulations. It occurs when one country manipulates exchange rate against the
interest of other country.
Merits of fixed exchange rate:-
i) Market stability and mobility of capital- Traders and investors are not exposed to
uncertainties of the market. It promotes international mobility of capital because of the certainty
among businesses and investors.
ii) No scope for speculation:-Till the government itself decides to change the exchange rate
there is no scope for speculative activities in foreign exchange market.
iii) Less inflation: - In the fixed exchange rate system there is no scope for the imported goods
becoming costlier on account of the rising exchange rate.
Note:- price of imported goods may rise because the price have risen in their countries of origin
but not because the exchange rate has risen in the country of destination.
Demerits of foreign exchange rate
i) large foreign exchange reserve required:- Government has to maintain stock of gold and
foreign currencies as a support to its fixed exchange rate policy. If there is shortage, government
starts selling foreign currency out of its reserves. In times of surpluses, it starts buying. This
becomes an unnecessary burden on the government.
ii) No automatic adjustment in the balance of payments:-In the fixed exchange rate system,
the automatic correction is not possible government has to resort to borrowings from foreign
government s and the international financial institutions, or withdraw from its reserves.
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Foreign exchange rate (Macro)
iii) Increases dependence on external sources –Borrowings from foreign government and from
international financial institution reduces independence of government in policy making. The
lenders put conditions regarding the use of borrowings which reduce economic interest of the
country.
How is foreign exchange rate (in case of flexible exchange rate) determined?
The foreign exchange rate is determined by demand for and supply of a given currency on
foreign exchange market.
On demand side
There is an inverse relation between price of foreign exchange and demand for that foreign
currency in terms of domestic currency. The higher (lower) the price, the lower ( higher) is the
demand for foreign currency.
Note:-Why is foreign exchange demanded?
It is demanded for purpose of:-
1) Payments of international loans
2) Gifts and grants to rest of the world
3) Investment in rest of the world
4) Direct purchases abroad as well as imports from rest of the world
5) Speculative trading in foreign exchange by our residents.
On supply side
There is direct relationship between price of foreign exchange and the supply of that foreign
exchange. Higher the prices, higher the supply of foreign exchange, and lower the price, lower
the supply.
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Foreign exchange rate (Macro)
Note:- What factors influence the supply of foreign exchange?
1) Exports of the country to rest of the world
2) Direct foreign investment.
3) Direct purchases of goods and services by non-residents in the domestic market
4) Remittances by the non-residents living in foreign countries
Determination of foreign exchange rate
Disequilibrium conditions:- (Floating exchange rate)
i) Appreciation of the currency (Dollar):- Suppose we consider the price of foreign currency
Rs per US Dollar in that case increase in demand for dollar can lead to appreciation of the
foreign currency.
Graphically, Demand (DD) The initial demand curve for the US $
Demand (DD1)A forward shift in demand curve for US $
Consequently, price of a US $ rises from OR to OP. It is a situation of a rise in exchange rate:
Dollar is appreciating while rupee is depreciating.
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Foreign exchange rate (Macro)
ii) Depreciation of the currency(Dollar):-Suppose we consider the price of foreign exchange
rate RS per US Dollars in that case increase in the supply of US dollars will cause depreciation
of foreign currency.
Graphically, SS Initial supply curve at US $
SS1 a forward shift in supply curve for US $
Consequently, price of US$ decreases from OR to OP. It is a situation of fall in exchange rate:
dollar is depreciating while rupee is appreciating
Note:-Distinguish between devaluation and depreciation of domestic currency
Devaluation Depreciation
It is the fall in the value of domestic currency It is the fall in the value of domestic currency
in relation to foreign currency as planned by in relation to foreign currency in a situation
the government in a situation when exchange when exchange rate is determined by the forces
rate is not determined by the forces of supply of supply and demand in the international
and demand but is fixed by the government of money market
different countries.
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Foreign exchange rate (Macro)
What are the consequences of devaluation or depreciation of domestic currency?
It results in fall in the value of domestic currency in terms of foreign currency consequently,
domestic goods become cheaper in terms of foreign currency. Accordingly, exports tend to rise
while imports are discouraged.
Merits of flexible exchange rate
i) Leads to automatic adjustment in the balance of payment:-Balance of payments is an
account of a country recording inflow and outflow of foreign exchange. These flows are of two
types: a) autonomous flows b) accommodating flows
When autonomous inflows are less than the autonomous outflows, the balance of payment
problem arises. This raises the demand for foreign currencies which, in turn leads to rise in the
foreign exchange rate. The rise in rate makes exports cheaper and imports dearer. Demand for
export rises and that of imports fall. As a consequence, inflow of foreign currency rises and that
of outflow falls. In this way balance of payment problem is solved.
ii) No need of exchange reserves: - Due to the automatic adjustment in the balance of
payments. There will be no shortage of foreign exchange. If here is any , the foreign
exchange market takes care of it. In this way, the system of floating exchange rate reduces
the responsibilities of government.
iii)No need to depend on external sources:- In the case of shortage of foreign exchange, the
government has no option but to borrow from the foreign governments and the
international financial institutions like the International monetary fund(IMF) etc, to meet
the shortage. This kind of dependence on external sources reduces independence of the
government in matters of programs and economic policies. Floating exchange rate makes
the government independent of foreign pressures.
Demerits of floating exchange rate
i) Uncertainty about future exchange rate :- Due to the time gap between taking a business
decision and executing the decision .It increases uncertainty among the businesses and investors
due to the volatile (showing frequent rise or fall in the exchange rate) nature of the exchange rate
in the flexible exchange rate system.
ii) Encourages Specultation:- it means trading in foreign currencies taking advantage of the
expected fluctuations in exchange rates. Speculation manipulates the market and makes the
exchange rates too low or too high. This may destabilize the foreign exchange market and
discourage foreign trade and foreign investment.
iii)May lead to inflationary tendencies:- exchange rate rises and rises very fast this makes
imports costlier. The prices of imported goods rise. This also led to rise in prices of the
domestically produced goods, which may lead to inflation in the country.
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