Foreign Exchange
Grade XII
Economics
Learning Objectives
To understand the meaning of foreign exchange
To understand the difference between fixed and flexible foreign
exchange rates
To understand the determination of flexible foreign exchange rate
To understand managed floating
Foreign Exchange
Foreign exchange refers to all the currencies of the rest of the
world other than the domestic currency of the country. For
example, in India, US dollar is the foreign exchange.
2. The rate at which one currency is exchanged for another is
called Foreign Exchange Rate.
For example, if one U.S dollar exchanges for 60 Indian
rupees, then the rate of exchange is 1$ = Rs. 72 or 1 Rs = 1/72
or 0.0138 U.S. dollar.
3. Foreign exchange market is the market where the national
currencies are converted, exchanged or traded for one another.
Foreign Exchange Market
The market in which national
currencies are traded for one another
is known as the foreign exchange
market.
Functions of Foreign Exchange Market
(a) Transfer Function: Transfer function refers to
transferring of purchasing power among countries.
(b) 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.
(c) 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.
Sources of Demand of Foreign Exchange
(a) Imports of Goods and Services
(b) Tourism
(c) Unilateral Transfers Sent Abroad
(d) Purchase of Assets in Foreign Countries
(e) Repayment of loans to Foreigners
(f) Speculation
Reasons for ‘Rise in Demand’ for Foreign
Currency
(a) 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.
(b) When a foreign currency becomes cheaper in
terms of the domestic currency, it promotes tourism
to that country.
(c) When price of a foreign currency falls, its demand
rises as more people want to make gains from
speculative activities.
Sources of Supply of Foreign Exchange:
(a) Exports of Goods and Services
(b) Tourism
(c) Remittances (unilateral transfers) from Abroad
(d) Loan from Rest of the world
(e) Foreign Investment
(f) Speculation
Reasons of Rise in Supply of Foreign Currency
(a) When price of a foreign currency rises, domestic
goods become relatively cheaper.
(b) When price of a foreign currency rises, foreign
direct investment (FDI). from rest of the world
increases, which will increase the supply for foreign
exchange.
(c) When price of a foreign currency rises, supply of
foreign currency also rises as people want to make
gains from speculative activities
Exchange Rate Regimes
Fixed Exchange Rate
Flexible Exchange Rate
Managed Floating Exchange Rate
Fixed Exchange Rate (Pegged Exchange Rate)
(i) The system of exchange rate in which exchange rate is officially
declared and fixed by the government is called fixed exchange rate
system.
(ii) When domestic currency is tied to the value of foreign
currency, it is known as pegging.
(iii) To maintain stability in fixed exchange rate system,
government buy foreign currency when exchange rate appreciates
and sell foreign currency when exchange rate depreciate. This
process is called Pegging operation, i.e., all efforts made by the
central bank to keep the rate of exchange stable.
Flexible Exchange Rate (Floating Exchange Rate)
An exchange rate determined by the forces of demand and supply
in the foreign exchange market is known as flexible or floating
exchange rate.
In a completely flexible exchange rate system (i.e. clean floating),
the central banks do not intervene in the foreign exchange market.
A central bank does not maintain any reserves of foreign currency
as the market automatically adjusts to determine the market
driven exchange rate. Therefore, there is no official reserve
transactions.
Determination of Foreign Exchange Rate
Exchange rate in a
free exchange
market is
determined at a
point, where
demand for foreign
exchange is equal
to the supply of
foreign exchange.
Devaluation of domestic currency
It is the reduction in the value of domestic currency by
the government with respect to a given foreign currency.
OR
In a fixed exchange rate system, when the government
increases the exchange rate (thereby, making domestic
currency cheaper in terms of foreign currency) is called
devaluation of domestic currency.
Just opposite is Revaluation of domestic currency.
Depreciation of domestic currency
It means fall in the value of domestic currency caused by
a rise in the exchange rate under the flexible exchange
rate system.
It encourages exports as domestic goods become cheaper
for the foreign nationals. It will make imports of foreign
goods costlier.
Just opposite is Appreciation
Managed Floating Exchange Rates
(also called dirty floating)
In this process exchange rate is determined by the forces of
demand and supply of foreign exchange, but the central bank may
intervene to buy or sell foreign currency to control the exchange
rate fluctuations. Official reserve transactions are, therefore, not
equal to zero. This system is also called as ‘dirty floating’
This system is the amalgamation of the flexible exchange rate
system and the fixed exchange rate system because managed
floating exchange rate is decided by market forces (the float part)
but remains within a specific range as decided by central bank
(the managed part)
Review
1. What is the meaning of foreign exchange?
2. Distinguish between flexible and fixed exchange
systems.
3. What is managed floating exchange rate?
4. How is exchange rate determined under flexible
exchange rate system?
Recapitulation
1. The rate at which one currency is exchanged for another is called Foreign
Exchange Rate.
2. Foreign exchange market is the market where the national currencies are
converted, exchanged or traded for one another.
3. Sources of demand of foreign exchange:
(a) Imports of Goods and Services, (b) Tourism, (c) Unilateral Transfers Sent
Abroad, (d) Purchase of Assets in Foreign Countries and (d) Speculation.
4. Exchange rate in a free exchange market is determined at a point, where demand
for foreign exchange is equal to the supply of foreign exchange.
5. Types of exchange rate regimes are Fixed exchange rate system (Pegged exchange
rate system), Flexible exchange rate (floating exchange rate system) and Managed
floating rate system:
[Link] floating exchange rate is a mixture of a flexible exchange rate (the float
part) and a fixed exchange rate (the Managed part). Central Bank buys or sells
foreign exchange to stabilize it.
Thank you
