MEANING OF FOREIGN EXCHANGE RATE

All countries have their own currencies which are readily acceptable within their respective
territories. For example, Indian rupee in India, US Dollar in America, Pound in England, etc.

However, currency of one country is generally not accepted in some other country. In case of an
international payment, currency of one country has to be converted into the currency of another
country because every country wants the payment in its own currency.

FOREIGN EXCHANGE RATE:

It is the rate at which one currency is converted in to another currency.

Foreign Exchange rate measures the number of units of one currency required to exchange with one
unit of another. If exchange rate for pounds and dollars ls: E1 = $2, then it means that two dollars are
needed to have one pound.

The exchange rate can fluctuate from year-to-year or even day-to-day. In a country, there are as
many foreign exchange rates as there are foreign currencies. Like many other prices, exchange rate is
determined by forces of demand and supply.

CURRENCY DEPRECIATION VS CURRENCY APPRECIATION

Currency Depreciation

Currency Depreciation refers to decrease in the value of domestic currency in terms of foreign
currency. It makes the domestic currency less valuable and more of it is required to buy the foreign
currency.

For example:

(i) Rupee is said to be depreciating if price of $1 rises from ₹ 80 to ₹ 84.

(ii) A change from $2 = £1 to $1.5= £1 represents that UK pound is depreciating.

Effect of Depreciation of Domestic Currency on Exports

Depreciation of domestic currency means a fall in the price of domestic currency (say, rupee) in
terms of a foreign currency (say, $). It means, with same amount of dollars, more goods can be
purchased from India, i.e. exports to USA will increase as they will become relatively cheaper.

Currency Appreciation

Currency Appreciation refers to increase in the value of domestic currency in terms of foreign
currency. The domestic currency becomes more valuable and less of it is required to buy the foreign
currency.

For example:

(i) Indian rupee appreciates when price of $1 falls from ₹ 74 to ₹ 70.

(ii) A change from $1.5 = £1 to $2 = £1 represents that the UK pound is appreciating.

Effect of Appreciation of Domestic Currency on Imports

Appreciation of domestic currency means a rise in the price of domestic currency (say, rupee) in
terms of a foreign currency (say, $). Now, one rupee can be exchanged for more $, i.e. with same
amount of money, more goods can be purchased from USA. It leads to increase in imports from USA
as American goods will become relatively cheaper.
TYPES OF FOREIGN EXCHANGE RATES

The three main types of exchange rate systems are:

1. Fixed Exchange Rate System (or Pegged Exchange Rate System).

2. Flexible Exchange Rate System (or Floating Exchange Rate System).

3. Managed Floating Rate System.

Fixed Exchange Rate System

Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed by the
government.

· The basic purpose of adopting this system is to ensure stability in foreign trade and capital
movements.

· To achieve stability, government undertakes to buy foreign currency when the exchange rate
becomes weaker and sell foreign currency when the rate of exchange gets stronger.

· For this, government has to maintain large reserves of foreign currencies to maintain the exchange
rate at the level fixed by it.

. Under this system, each country keeps value of its currency fixed in terms of some 'External
Standard'.

· This external standard can be gold, silver, other precious metal, another country's currency or even
some internationally agreed unit of account.

. When value of domestic currency is tied to the value of another currency, it is known as 'Pegging'.

. When value of a currency is fixed in terms of some other currency or in terms of gold, it is known as
'Parity value' of currency.
Devaluation and Revaluation

Devaluation refers to reduction in the value of domestic currency by the government. Devaluation is
said to occur when the exchange rate is increased by the government under Fixed Exchange Rate
System. On the other hand, Revaluation refers to increase in the value of domestic currency by the
government.

Flexible Exchange Rate System

Flexible exchange rate system refers to a system in which exchange rate is determined by forces of
demand and supply of different currencies in the foreign exchange market.

· The value of currency is allowed to fluctuate freely according to changes in demand and supply of
foreign exchange.

· There is no official (Government) intervention in the foreign exchange market.

· Flexible exchange rate is also known as 'Floating Exchange Rate'.

· The exchange rate is determined by the market, i.e. through interactions of thousands of banks,
firms and other institutions seeking to buy and sell currency for purposes of making transactions in
foreign exchange.
Managed Floating rate System
It refers to a system in which foreign exchange rate is determined by market forces and central bank
influences the exchange rate through intervention in the foreign exchange market.

. It is a hybrid of a fixed exchange rate and a flexible exchange rate system.

. In this system, central bank intervenes in the foreign exchange market to restrict the fluctuations in
the exchange rate within certain limits. The aim is to keep exchange rate close to desired target
values.

· For this, central bank maintains reserves of foreign exchange to ensure that the exchange

rate stays within the targeted value.

. It is also known as 'Dirty Floating’

DEMAND FOR FOREIGN EXCHANGE

The demand (or outflow) of foreign exchange comes from those people who need it to make
payment in foreign currency. It is demanded by the domestic residents for the following reasons:

1. For Imports of Goods and Services: Foreign Exchange is demanded to make the payment for
imports of goods and services.

2. Foreign Tourism: Foreign exchange is needed to meet expenditure incurred in foreign tours.

3. Unilateral Transfers sent abroad: Foreign exchange is required for making unilateral transfers like
sending gifts to other countries.

4. Purchase of Assets in Foreign Countries: It is demanded to make payment for purchase of assets,
like land, shares, bonds, etc. in the foreign countries.

5. Speculation: Demand for foreign exchange arises when people want to make gains from
appreciation of currency.

For example, if people expect that the price of US dollar in terms of money would increase in future,
they will buy more US dollars today. They will do so to make gains from appreciation of currency, i.e.
in the expectation of making profits when dollar becomes expensive.

Reasons for 'Rise in Demand' for Foreign Currency

The demand for foreign currency rises in the following situations:

1. When price of a foreign currency falls, imports from that foreign country become cheaper. So,
imports increase and hence, the demand for foreign currency rises. For example, if price of 1 US
dollar falls from ₹ 74 to ₹ 70, then imports from USA will increase as American goods will become
relatively cheaper. It will raise the demand for US dollars.

2. When a foreign currency becomes cheaper in terms of the domestic currency, it promotes tourism
to that country. As a result, demand for foreign currency rises.

3. When price of a foreign currency falls, its demand rises as more people want to make gains from
speculative activities.
Demand Curve of Foreign Exchange
Demand curve of foreign exchange slope downwards

due to inverse relationship between demand for foreign

exchange and foreign exchange rate.

In Fig., demand for foreign exchange (US dollar)

and rate of foreign exchange are shown on the X-axis

and Y-axis respectively. The negatively sloped demand

curve (DD) shows that more foreign exchange (OQ,)

is demanded at a low rate of exchange (OR,), whereas,

demand for US dollars falls to OQ2 when the exchange

rate rises to OR2.

SUPPLY OF FOREIGN EXCHANGE

The supply (inflow) of foreign exchange comes from those people who receive it due to following
reasons.

1. Exports of Goods and Services: Supply of foreign exchange comes through exports of goods and
services.

2. Foreign Investment: The amount, which foreigners invest in the home country, increases the
supply of foreign exchange.

3. Remittances (Unilateral transfers) from abroad: Supply of foreign exchange increases in the form of
gifts and other remittances from abroad.

4. Speculation: Supply of foreign exchange comes from those who want to speculate on the value of
foreign exchange.

Reasons for 'Rise in Supply' of Foreign Currency

The supply of foreign currency rises in the following situations:

1. When price of a foreign currency rises, domestic goods become relatively cheaper. It induces the
foreign country to increase their imports from the domestic country. As a result, supply of foreign
currency rises. For example, if price of 1 US dollar rises from ₹ 70 to ₹ 74, then exports to USA will
increase as Indian goods will become relatively cheaper. It will raise the supply of US dollars.

2. When price of a foreign currency rises, supply of foreign currency rises as people want to make
gains from speculative activities.
Supply Curve of Foreign Exchange
Supply curve of foreign exchange slope upwards due

to positive relationship between supply for foreign

exchange and foreign exchange rate.

In Fig., supply of foreign exchange (US Dollar)

and rate of foreign exchange have been shown on

the X-axis and Y-axis respectively. The positively

sloped supply curve (SS) shows that supply of foreign

exchange rises from OQ, to OQ2 when the exchange

rate rises from OR, to OR2.

11.6 DETERMINATION OF EXCHANGE RATE

Like the price of a commodity, flexible exchange

rate is determined by the interaction of the forces of

demand and supply. The equilibrium exchange rate is

determined at a level where demand for foreign exchange

is equal to the supply of foreign exchange. This will be

clear from Fig.

As seen in the diagram, demand and supply of foreign

exchange are measured on the X-axis and rate of

foreign exchange on the Y-axis. DD is the downward

sloping demand curve of foreign exchange and

SS is the upward sloping supply curve of foreign

exchange. Both the curves intersect each other at point

'E'. The equilibrium exchange rate is determined at OR

and equilibrium quantity is determined at OQ.

Any Exchange Rate (other than OR) is not the Equilibrium Exchange Rate

. If the exchange rate rises to OR,, then demand for foreign exchange will fall to OQ2 and supply will
rise to OQ,. It will be a situation of excess supply. As a result, exchange rate will fall till it again
reaches the equilibrium level of OR.

. If exchange rate falls to OR,, then demand will rise to OQ, and supply will fall to OQ2. It will be a
case of excess demand. It will push up the exchange rate till it reaches OR.
CHANGES IN EXCHANGE RATE
The equilibrium exchange rate will be disturbed if some changes occur in the demand or supply of
foreign exchange.

Change in Demand
Change in demand may be either an 'Increase in Demand' or 'Decrease in Demand'.

(i) Increase in Demand: An increase in demand for

foreign exchange will shift the demand curve

towards right from DD to D1D1. In Fig, there is

an excess demand of QQ, at the original exchange

rate of OR. As a result, the exchange rate rises

to OR. It shows that per unit price of US Dollar

(in terms of rupees) has increased, i.e. domestic

currency has depreciated.

ii) Decrease in Demand: A decrease in demand will

shift the demand curve towards left (Fig.)

from DD to D2D2. It leads to deficit demand of QQ

at the original exchange rate of OR. As a result,

exchange rate will fall till it reaches OR2. Now, per

unit price of US Dollar (in terms of rupees) has

decreased, i.e. domestic currency has appreciated.

Change in Supply
Change in supply may be either an 'Increase in Supply'

or 'Decrease in Supply'.

(i) Increase in Supply: If supply of foreign exchange

increases, it will lead to a rightward shift in

supply curve from SS to S1S1, as shown in Fig. 11.5.

Now, at the original exchange rate of OR, there

is an excess supply of QQ3. As a result, the new

exchange rate moves down to OR. This implies

that per unit price of US Dollar (in terms of rupees)

has reduced. A decrease in the price of foreign

currency, in terms of domestic currency, means

that the domestic currency has appreciated.

(ii) Decrease in Supply: A decrease in supply will shift the supply curve towards left (Fig. 11.5) from
SS to S2S2. It leads to deficit supply of QQ, at the original exchange rate of OR. This will increase the
exchange rate till it reaches OR,. So, per unit price of US Dollar (in terms of rupees) has increased
and, thus, the domestic currency has depreciated.

FOREIGN EXCHANGE MARKET

Foreign exchange market is the market in which foreign currencies are bought and sold. The buyers
and sellers include individuals, firms, foreign exchange brokers, commercial banks and the central
bank.

Like any other market, foreign exchange market is a system, not a place. The transactions in this
market are not confined to only one or few foreign currencies. In fact, there are a large number of
foreign currencies which are traded, converted and exchanged in the foreign exchange market.

Functions of Foreign Exchange Market

Foreign exchange market performs the following three functions:

1. Transfer Function: It transfers purchasing power between the countries involved in the
transaction. This function is performed through credit instruments like bills of foreign exchange, bank
drafts and telephonic transfers.

2. Credit Function: It provides credit for foreign trade. Bills of exchange, with maturity period of
three months, are generally used for international payments. Credit is required for this period in
order to enable the importer to take possession of goods, sell them and obtain money to pay off the
bill.

3. Hedging Function: When exporters and importers enter into an agreement to sell and buy goods
on some future date at the current prices and exchange rate, it is called hedging. The purpose of
hedging is to avoid losses that might be caused due to exchange rate variations in the future.

Kinds of Foreign Exchange Markets

Foreign exchange markets are classified on the basis of whether the foreign exchange transactions
are spot or forward. Accordingly, there are two kinds of foreign exchange markets: (i) Spot Market;
(ii) Forward Market.

(i) Spot Market: Spot market refers to the market in which the receipts and payments are made
immediately. Generally, a time of two business days is permitted to settle the transaction.

(ii) Forward Market: Forward market refers to the market in which sale and purchase of foreign
currency is settled on a specified future date at a rate agreed upon today. The exchange rate quoted
in forward transactions is known as the forward exchange rate. Generally, most of the international
transactions are signed on one date and completed on a later date. Forward exchange rate becomes
useful for both the parties involved in the transaction. Forward Contract is made for two reasons: (a)
To minimise the risk of loss due to adverse changes in the exchange rate (through hedging); (b) To
make profit (through speculation).