Foreign exchange

Meaning of foreign exchange

• Foreign exchange means foreign currency.
• For Indians American dollar, British pound, Japanese yen, are foreign exchange.

Meaning of foreign exchange rate

• The rate at which currency of one country can be exchange for currency of another
country is called the rate of foreign exchange.
• For Instance ,if one American dollar can be obtained for 50 Indian rupees then
foreign exchange rate is $ 1= ₹50.(or ₹ 1=1/50 dollar = 2 cents).

Nominal and real exchange rate

1. Nominal exchange rate:
Nominal Exchange rate is the price of foreign currency in terms of domestic currency.
2. Real Exchange rate:
Real exchange rate is the relative price of foreign Currency in terms of domestic
Currency.

Meaning of foreign exchange market

• The market in which national currency of various countries are converted, exchanged
or traded for one another is called foreign exchange market.
• It is not any physical place but is a network of communication system which connect
the whole complex of institutions.
• It includes banks, specialised foreign exchange dealers, brokers and official
government agencies.

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 Functions of Foreign exchange rate
• Transfer function
• Credit Function
• Hedging function

Spot market and forward Market

1. Spot Market:
• A market that handles only spot transactions or current transaction in foreign
exchange is called spot market.
• The exchange rate that prevails in the spot market for foreign exchange is called spot
rate.
2. Forward Market:
• A market in which foreign exchange is bought and sold for future delivery is known as
forward Market.
• Exchange rate that prevails in forward contract for purchase or sale of foreign
exchange is called forward rate.

A forward contract is entered into for two reasons:

• To minimise risk of loss due to adverse change in exchange rate.
• To make a profit ( i.e speculation).

Types of foreign exchange rate system

1. Fixed exchange rate system.
Meaning of fixed exchange rate system.
• Fixed exchange rate system refers to the system in which the rate of exchange for a
currency is fixed by the government.
• Under fixed exchange rate system, each country maintains value of its currency fixed
in terms of cold, silver, other precious metal, another countries currency etc.
• Gold standard system of exchange rate (1870-1914).
• According to this system, gold was taken as the common unit of parity between
currencies of different countries.
• Each country defined value of its currency in terms of gold.

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Merits of fixed exchange rate
• It ensures stability in exchange rate.
• Coordination of macro policies becomes convenient.
• It prevents speculation in foreign exchange market.

Demerits of fixed exchange rate

• It does not encourage venture capital.
• There is possibility of under or over valuation of the currency.
• Government has to maintain 100% gold reserves.
2.Flexible exchange rate system
Meaning of flexible exchange rate
• It refers to the system in which exchange rate between currencies of different
countries is determined by the market forces of demand and supply.
• There is no government intervention in the foreign exchange rate.
• The exchange rate at which demand for foreign currency is equal to its supply is
called per rate of exchange ,normal rate or equilibrium rate of foreign exchange.

Merits of flexible exchange rate system

• It solve the problem of overvaluation or undervaluation of currencies.
• There is no requirement of government to hold 100% gold reserves.
• It encourages venture capital.
Demerits of flexible exchange rate
• There is no stability flexible exchange rate keeps fluctuating according to demand
and supply.
• This discourages international trade and coordination of macro policies becomes
inconvenient.
3.Managed floating rate system
Meaning of managed floating rate system:
• It refers to a system in which foreign exchange rate is determine by market forces
and Central Bank stabilizes the exchange rates in case of appreciation or depreciation
of domestic currency.

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• When the exchange rate is high, the central bank starts selling foreign exchange to
bring it down and vice versa. it is done to protect the interest of importers and
exporters.
• It is called a “hybrid” system between fixed rate and flexible exchange rate.

Fixed exchange rate and flexible exchange rate

1. Fixed exchange rate:
• Meaning:Fixed exchange rate is fixed in terms of gold or any other currency by the
government.
• Effect of market forces: it does not change with changes in demand and supply of
foreign exchange in the market.
• Central of government: There is full government control in determining the
exchange rate.
• Stability: Fixed exchange rate generally remains stable any variation is initiated by
the government.
2. Flexible exchange rate:
• Meaning: flexible exchange rate is determined by the market forces of demand and
supply of foreign currency.
• Effect of market forces: Flexible exchange rate changes with changes in demand and
supply of foreign exchange in the market.
• Central of government: There is no government intervention in determining the
exchange rate.
• Stability: Flexible exchange rate changes whenever there is change in market forces
of demand and supply.

Depreciation and appreciation

3. Depreciation:
• Depreciation refers to fall in value of domestic currency in terms of a foreign
currency under flexible exchange rate regime.
• Depreciation occurs in a flexible exchange rate system.
• Depreciation takes place under the influence of changes in demand for and supply of
a currency.

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4. Appreciation:
• Appreciation Refers to rise in value of domestic currency in terms of a foreign
currency under flexible exchange rate regime.
• Appreciation occurs in a flexible exchange rate system.
• Appreciation takes place under the influence of changes in demand for and supply of
a currency.

Effect of depreciation on exports: it encourages exports.

• Depreciation of domestic currency means a fall in the value of the domestic currency
in terms of foreign currency. For example ,if price of 1$ rises from ₹60 to ₹70.
• It means that one dollar can be exchanged for more rupees.
• It implies that with same one dollar, more goods can be purchased from India.
• It means that imports by USA will increase or depreciation of currency will encourage
exports.

Effect of depreciation on imports: it discourages imports

• Depreciation means a fall in the value of the domestic currency in terms of foreign
currency for example if price of 1$ rises from ₹60 to ₹70.
• It means that one dollar will be exchanged for more rupees.
• It implies that more of domestic currency is required to buy goods worth 1 dollar.
• It means that imports from USA have become costlier, therefore imports will
decrease or depreciation of currency will discourage imports.

Effect of appreciation on exports: it is discourages exports

• Appreciation of domestic currency means an increase in the value of the domestic
currency in terms of foreign currency. For example ,if price of 1$ falls from ₹60 to
₹50.
• It means that one and can be exchanged for less rupees.
• It implies that with same one dollar,less goods can be purchase from India.
• It will discourage imports by USA, therefore exports to USA will decrease.
Effect of appreciation of domestic currency on imports: it encourages imports
• Appreciation of domestic currency means an increase in the value of the domestic
currency in terms of foreign currency. for example ,if price of 1$falls from ₹60 to ₹50.

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• It means that one dollar will be exchanged for less rupees.
• It implies that for same one dollar, less units of domestic currency are required.
• It will encourage imports from USA, therefore imports from USA will increase.

Devaluation and revaluation

5. Devaluation
• Devaluation refers to reduction in value of domestic currency in terms of a foreign
currency under fixed exchange rate regime.
• It is done in a fixed exchange rate system.
• Devaluation is done by government deliberately to correct BOP situation.
6. Revaluation
• Revaluation refers to increase in value of domestic currency in terms of a foreign
currency under fixed exchange rate regime.
• Revaluation is done in a fixed exchange rate system.
• Revaluation is done by government deliberately to correct the BOP situation.

Sources of demand for foreign exchange

Foreign exchange is demanded by domestic residents for the following reasons:
• To purchase goods and services by domestic residents from foreign countries.
• To purchase financial assets(i.e, to invest in bonds and equity shares) by domestic
residents in a foreign country.
• To invest directly in shops, factories, buildings in foreign countries.
• To send gifts and grants abroad.
• To Undertake foreign tours.
• To speculate on the value of foreign currencies.
• To make payments of international trade.

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Relation between price of foreign exchange and demand for foreign exchange

There is an inverse relationship between the price of foreign exchange and the demand
for foreign exchange i.e at a higher price, less of the foreign exchange is demanded and
Vice-versa.
Sources of supply of foreign exchange
Supply of foreign exchange comes from foreigners who make us payment in foreign
exchange for different purposes.
• When foreigners purchase home countries goods and services through exports.
• When foreigners invest in bonds and equity shares of the home country.
• When currency dealers and speculators cause flow of foreign currency in the
domestic economy.
• When Indian workers working abroad send their savings to families in India.
• When foreign tourists comes to India.

Relation between the price of foreign exchange and supply of foreign exchange

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The supply of foreign exchange has a direct relationship with the price of foreign
exchange.
• If the price of foreign exchange goes up,the quantity supplied of foreign exchange
will also rise.
• If price of foreign exchange falls, the quantity supplied of foreign exchange will also
fall.

Determinants of equilibrium rate of foreign exchange

Equilibrium rate of exchanges is established at a point where the quantity demanded

and the quantity supplied of foreign exchange are equal.

Observations
• Negatively slope demand curve and positively slope supply curve (ss) of foreign
exchange intersect each other at point e.
• Point e shows equilibrium between demand and supply of foreign exchange.
• Point e corresponds to equilibrium rate of exchange which is OR.
• At this price (OR), OM quantity of foreign exchange is demanded and supplied.
Causes of change in rate of foreign exchange
• Currency depreciation (when exchange rate rises).
• Currency appreciation (when exchange rate falls).

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Increase in demand for foreign exchange

Observations
• Due to increase in demand DD curve shifts to right (DD-D1D1).
• New equilibrium point E1 is achieved.
• It shows rise in exchange rate from OR to OR 1.
• It shows depreciation of domestic currency.
Fall in demand of foreign currency

Observations
• Due to decrease in demand, DD curve shifts to left (DD-D2D2).
• New equilibrium point E2 is achieved.
• It shows fall in exchange rate from OR to OR2.
• It implies appreciation of domestic currency.

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Rise in supply of foreign currency

Observations
• Due to increase in supply, the supply curve shift to right (SS-S2S2).
• New equilibrium point e2 is achieved.
• It shows fall in exchange rate from OR to OR2 .
• It implies appreciation of domestic currency.
Decrease in supply of foreign currency

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Observations
• Due to decrease in supply the supply curve shifts to left (SS-S1S1).
• New equilibrium point e1 is achieved.
• It shows rise in exchange rate from OR to OR 1 .
• It shows depreciation of domestic currency.

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