Foreign Exchange Rate

Foreign exchange rate refers to the rate at which one unit of currency of a country can be exchanged
for the number of units of currency of another country. In other words, it is the price paid in the
domestic currency in order to get one unit of foreign currency.
Example: $ 1 = ₹ 74 or ₹ 1 = $ 1
Type of Exchange Rate:
Broadly, two systems (or types) of exchange rate have evolved over time:
1. Fixed Exchange Rate System
2. Flexible Exchange Rate System
1. Fixed Exchange Rate System:
Fixed exchange rate refers to rate of exchange as fixed by the government. Historically it has two
important variants:
a) Gold Standard System of Exchange Rate
b) Bretton Woods System of Exchange Rate or Adjustable Peg System of Exchange Rate
a) Gold Standard System of Exchange Rate:
• According to this system (prevalent in most countries prior to 1920s), gold was taken as the common
unit of parity between currencies of different countries in circulation.
• 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.
• Example: If 1 UK ₤ (Pound) = 4 g of gold and 1 US $ (Dollar) = 2 g of gold, then 1 UK ₤ = 2 US $.
Exchange rate between UK ₤ and US $ = 1:2.
b) Bretton Woods System of Exchange Rate:
• Bretton Woods system, even when it was a fixed system of exchange rate, allowed some
adjustments. So, it was called ‘adjustable peg system of exchange rate’. According to this system,
• Different currencies were pegged (or related to) to one currency, that is US dollar.
• US dollar was assigned gold value at a fixed price.
• Value of one currency in terms of US dollar ultimately implied value of that currency in terms of gold.
• Gold continued to be the ultimate unit of parity between any two currencies.
• Adjustments in the parity value of a currency was possible but only if allowed by IMF.
2. Flexible Exchange Rate System:
Flexible rate of exchange is that rate which is determined by the demand for 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.
Demand for Foreign Exchange:
• Foreign exchange is demanded for the following reasons:
▪ Repayment of international loans
▪ Investment in rest of the world ▪ Imports
▪ Direct purchases abroad ▪ Grants and donations to abroad
▪ Payment of income to abroad
▪ Speculative trading.
• Other things remaining constant, demand for foreign exchange is inversely related to the rate of
foreign exchange. This is shown below by a downward sloping demand curve for foreign exchange.

Supply of Foreign Exchange:

• Foreign currency flows into the home country due to the following reasons:
▪ Loans from rest of the world
▪ Investment from rest of the world like FDI
▪ Exports ▪ Direct purchases by rest of the world
▪ Grants and donations from rest of the world
▪ Income receipts
▪ Remittances by Non-residents
• Other things remaining constant, supply of foreign exchange is positively related to the rate of
foreign exchange. This is shown by an upward sloping supply curve of foreign exchange.
Equilibrium Exchange Rate.
Equilibrium exchange rate occurs when demand for foreign exchange = supply of foreign exchange.
Diagrammatically is corresponds to a point where demand and supply curves of foreign exchange
intersects each other. It is shown in the following diagram:

✓ Merits and Demerits of Fixed Exchange Rate System:

Merits Demerits
Market Stability: Stability of the market is key Reserves of Forex: To maintain the rate of
merit of the fixed exchange rate. It promotes exchange at the desired level, the government
investment across nations. need to keep a large stock of foreign exchange.
This is the principal demerit of the fixed
exchange rate system.
Stable Macroeconomic Policies: Given the fixed Inefficient Allocation of Resources: Exchange
exchange rate, the central bank can frame its rate fixed by the government often deviates
monetary policy and government can make its from the equilibrium exchange rate (in a free
fiscal policy, independent of the external shocks market economy). To that extent, allocation of
relating to fluctuations in exchange rate. resources may not be efficient.
Devaluation: Fixed exchange rate system allows Small Size of Forex Market: When the rate of
 devaluation of the currency. It helps expand exchange is fixed, foreign exchange does not
foreign market for the domestic producers. emerge as a trading commodity. Accordingly,
size of the forex market remains small. This acts
as a hurdle in the global economic growth.
Speculative Attack on a Currency: If rupee is
expected to be devalued in relation to US dollar,
the investors would start buying dollars
aggressively. Such speculative attack often forces
the government to reset the rate of exchange.

✓ Merits and Demerits of Flexible/Floating Exchange Rate System:

Merits Demerits
Large Reserves of Forex not required: In this Uncertainty of the Market: There is a high
system large reserves of forex are not required degree of uncertainty in the market. It becomes
as market forces of supply and demand difficult to formulate a stable monetary policy in
automatically drive the rate of exchange to the the domestic economy.
point of equilibrium.
Efficient Allocation of Resources: Efficient External Shocks: Flexible exchange rate system
allocation of resources is achieved, as the system exposes the domestic economy to external
is ruled by the free play of the market forces. shocks. Example: When US dollar appreciates,
the burden of import payments tends to rise
even when the international price of the goods is
constant.
Large Size of Forex: Since foreign exchange itself Marginalisation of Weak Currencies: Weak
becomes a trading commodity, the size of the currencies (of small economies) often suffer
forex market tends to be large. This induces huge depreciation in relation to strong
economic growth. currencies (of big economies).
International Mobility of Liquidity: Flexible
exchange rate tends to promote international
mobility of liquidity. This is good for the growth
of developing countries where foreign
investment is a significant determinant of GDP
growth.

❖ MANAGED FLOATING SYSTEM OF EXCHANGE RATE

• In simple terms, a managed floating exchange rate system is a system where currencies fluctuate
daily but the regulatory authorities, including the government and the Reserve bank of India, may step
in to control and stabilize the value of the currency.
• The central bank intervenes by selling or buying the foreign exchange in foreign exchange market as
per the requirements.
• If these bodies do not step in, there is bound to be an ‘economic shock’ to the country.
• A managed floating exchange rate is occasionally called a ‘dirty float’ as opposed to a ‘clean float’
where central banks do not intervene.
• It can be safely said that a managed float is a hybrid control system. It is neither a free-float nor a
flexible float exchange rate.

❖ DEVALUATION AND DEPRECIATION

Devaluation and depreciation both affect the value of a country's currency. Both of them lead to a fall
in the value of a country’s currency in terms of other currency. However, the manner in which this
happens is very different.
• Devaluation of a currency
Devaluation of a currency is associated with a fixed exchange rate regime. When the government or
the central bank reduces the value of its currency, then it is known as the devaluation of the currency.
Under this, the value of the domestic currency is deliberately reduced in terms of other foreign
currencies. For example, if the value of INR is reduced from $1 = ₹ 74 to $1 = ₹ 80 by the central bank
or government, then it is called Devaluation of Indian rupee.
• Depreciation of a currency
Depreciation of a currency is a phenomenon associated with countries with floating exchange rate
regime. When the value of a currency reduces in terms of other foreign currencies due to market
forces of demand and supply, then it is known as the depreciation of a currency. For example, if the
value of INR reduces from $1 = ₹ 74 to $1 = ₹ 80 by the market forces of supply and demand of foreign
exchange, then it is called Depreciation of Indian rupee.
❖ REVALUATION AND APPRECIATION
Revaluation and Appreciation both lead to a rise in the value of a country’s currency in terms of other
currency. However, the manner in which this happens is very different.
• Revaluation of a currency
Revaluation of a currency is associated with a fixed exchange rate regime. When the government or
the central bank increases the value of its currency, then it is known as the revaluation of the currency.
Under this, the value of the domestic currency is deliberately increased in terms of other foreign
currencies. For example, if the value of INR is increased from $1 = ₹ 74 to $1 = ₹ 70 by the central bank
or government, then it is called Revaluation of Indian rupee.
• Appreciation of a currency
Appreciation of a currency is a phenomenon associated with countries with floating exchange rate
regime. When the value of a currency increases in terms of other foreign currencies due to market
forces of demand and supply, then it is known as the appreciation of a currency. For example, if the
value of INR increases from $1 = ₹ 74 to $1 = ₹ 70 by the market forces of supply and demand of
foreign exchange, then it is called Appreciation of Indian rupee.
 DEVALUATION/DEPRECIATION
&
REVALUATION/APPRECIATION

DEVALUATION/DEPRECIATION REVALUATION/APPRECIATION
↓Decrease in the value of ↑ Increase in the value of domestic
domestic currency currency

DEVALUATION DEPRECIATION REVALUATION APPRECIATION

(Due to (Due to Market (Due to (DUE TO MARKET
FORCES)
Government) Forces) Government)