FOREIGN EXCHANGE RATE
MONEY: It refers to anything which is accepted as a medium of exchange.
CURRENCY: It is a generally accepted form of money, including coins and paper notes, which are issued by the government and circulated within an economy.
HARD CURRENCIES: Refers to those currencies which are easily accepted by the REST OF THE WORLD (ROW) for trade. For example, the British pound, US dollar, euro
SOFT CURRENCIES: These are those foreign currencies that are required to settle the transactions in the country. For example, if India is importing goods from Sri Lanka, India will pay in Sri Lankan rupees.
FOREIGN EXCHANGE: It refers to all the currency other than the domestic currency of the country. An example of an Indian’s foreign exchange is the peso, dollar, euro, etc.
FOREIGN EXCHANGE RATE: It refers to the rate at which one currency is exchanged for the other currency. For example, 1$ can be exchanged for RS 65 so the value of 1RS is 1/65$. The exchange rate can fluctuate from year to year or even every day. Thus, the exchange rate expresses the rate of exchange between two countries. It is also known as the external value of the currency.
FOREIGN EXCHANGE RESERVES: It refers to the stock of international currencies that a country holds to transact with other countries.
REVALUATION OF CURRENCY: It refers to an increase in the value of the domestic currency in terms of foreign currency by the government.
APPRECIATION OF CURRENCY: It refers to an increase in the value of the domestic currency in terms of foreign currencies through market forces (demand and supply). For example, a change from $1= 75RS to $1= 70RS. It makes the foreign goods cheaper in the domestic country as more of such goods can now be purchased with the same amount of domestic currency. So, it leads to an increase in imports.
DEPRECIATION OF CURRENCY: It refers to a decrease in the value of the domestic currency in terms of foreign currencies through market forces (demand and supply). For example, a change from 1 UK pound = 60RS to 1 UK pound = 65RS. It makes domestic goods cheaper in a foreign country as more of such goods can now be purchased with the same amount of foreign currency. So, it leads to an increase in exports.
DEVALUATION OF CURRENCY: it refers to a reduction in the value of the domestic currency in terms of foreign currencies by the government.
- In the following case which currency is appreciating and which is depreciating (1 mark each)
- A change from 2€ = 4$ to 3€ = 2$
- A change from 95RS = 2$ to 150RS = 3 $
- The central bank takes steps to control the rise in the price of foreign exchange. Explain the economic values it involves as far as the common man is concerned. (3 marks)
- ‘Devaluation and depreciation of the currency are one of the same things. Do you agree? How do they affect the exports of the country? ( 4 marks)
- A policy initiated by the Indian government had an adverse impact on the value of rupees in relation to foreign exchange. What does this indicate? Discuss with the help of a numerical example. Also, explain its effects on the exports and imports of the country. (4 marks)
- Appreciation of the Indian rupee will occur when RS 75 has to be paid to exchange $ instead of the present rate of Rs 70/$. True or false. (1 mark).
- Depreciation of domestic currency leads to a rise in exports. True or false. (1 mark)
- Demand for American goods will rise in India due to the appreciation of Indian currency. True or false.
- Differentiate between devaluation of currency and depreciation of the currency. (3 marks)
- A change from Rs 140= 2$ to Rs 60 = 1$ indicates that Rs: (1 marks)
- Neither(a) nor (b)
- Either (a) or(b)
- Depreciating of domestic currency leads to a rise in (1 marks)
- Both (a) and (b)
- Neither (a) nor (b)
- Devaluation of the currency means: (1marks)
- Reduction in the value of the domestic currency by market forces
- Reduction in the value of the domestic currency by the government
- Both (a) and (b)
- Neither (a) nor (b)
- The value of $ 1 has gone down from Rs 73 to Rs 70 that: (1 marks)
- The Indian rupee has to appreciate
- Us dollar is depreciating
- Both (a) and (b)
- None of these
- Foreign exchange refers to (1marks)
- The price of one currency in terms of gold in the domestic market.
- Price of one currency determined by the government of another country
- The price of one currency in relation to other currency in the international money market
- None of the above
- The exchange rate is the price of currency expressed in terms:
- Another currency
- None of these
- In case of currency appreciation, fewer rupees are to be paid to buy one US dollar. True or false. (1 mark)
- When in the foreign exchange market, the price of foreign currency rises in terms of domestic currency, it is termed as ______ in domestic currency. (1 mark)
TYPES OF FOREIGN EXCHANGE RATE
- Fixed exchange rate system
- Flexible exchange rate system
- Managed floating exchange rate
FIXED EXCHANGE RATE SYSTEM
- It refers to the system in which the rate of exchange is fixed by the government.
- The basic purpose of adopting this system of exchange is to ensure stability in foreign trade and capital movements.
- Under this system, each country keeps the value of its currency fixed in terms of some external standards.
- For this government has to maintain large reserves of foreign currencies to maintain the exchange rate at the level fixed by it.
- It has two variances: the gold standard system of exchange and the Bretton woods system.
- It is also known as pegged exchange rate system.
PEGGING: when the value of a domestic currency is tied to the value of another currency.
PARITY VALUE: when the value of a currency is fixed in terms of some other currency or the terms of gold.
GOLD STANDARD SYSTEM OF EXCHANGE
- This system prevails during the period ranging from 1870 to 1971.
- Under this system, gold was taken as a common unit of parity between currencies of different countries.
- All currencies were defined in terms of gold.
- Accordingly, the value of one currency in terms of other currency was fixed by considering the gold value of each currency.
- For example, UK pound = 4g of gold, US dollar = 2g of gold, therefore 1 UK pound = 2 US dollar. The exchange rate or exchange ratio between the UK pound and US dollar is 1:2.
- This system of exchange was also known as MINT PAE VALUE OF EXCHANGE or MINT PARITY.
BRETTON WOODS SYSTEM
- It is also known as the ADJUSTABLE PEG SYSTEM.
- After the break down of the gold standard system, the Bretton wood system was adopted.
- Gold was replaced by the US dollar.
- Under this system, all the currencies were pegged to the US dollar at a fixed exchange rate.
- This system gave birth to International Momentary Fund (IMF) as a central institutional momentary system.
MERITS OF FIXED FORIEGN EXCHANGE RATE SYSTEM
- Stability in the exchange rate
- Promotes international investment
- Promotes international trade
- Prevents speculative activities
- Co-ordinates macroeconomics policies
- Huge foreign exchange reserves are required
- Difficulty in fixing the exchange rate
- Exchange rates are not fixed.
FLEXIBLE EXCHANGE RATE SYSTEM
- Scarcity of gold and its inequality availability across different nations and due to increasing demand led to the decay of the fixed exchange rate system.
- The fixed exchange rate system was replaced by a flexible exchange rate system in 1977.
- Under this system exchange rate is determined by market forces (demand and supply) of different currencies in the foreign exchange market.
- The value of the currencies is allowed to fluctuate freely according to changes in demand and supply of foreign exchange.
- There is no official intervention in this system.
- It is also known as a floating exchange rate system.
- The exchange rate at which the demand of currency is equal to its supply is known as the par rate of exchange or equilibrium rate of exchange.
MERITS OF FLEXIBLE FORIEGN EXCHANGE RATE SYSTEM
- Maintains equilibrium level
- No need for huge foreign exchange reserves
- Optimum utilization of resources
DEMERITS OF FLEXIBLE FORIEGN EXCHANGE RATE SYSTEM
- Instability in the exchange rate
- Speculative activities
- Creates inflationary situation
MANAGED FLOATING FORIEGN EXCHANGE RATE
- This system is in a blend of the fixed and flexible exchange rate.
- It refers to a system in which the foreign exchange rate is determined by market forces and the central bank intervenes to manage the exchange rate so, that it doesn’t slip out of the desired limit.
- The central bank has some powers to manage the exchange rate slightly but after the permission from IMF (international momentary fund).
- It is also known as dirty floating.
- ‘Managed floating exchange rate is decided by market forces but remains within a specific range as decided by central bank’. True or false. (1 mark)
- Define fixed exchange rate. How is the exchange rate is determined in a flexible exchange rate system? (6 marks)
- _____ is the exchange rate determined by the market forces of supply and demand of foreign exchange. (1mark)
- State two merits and demerits of flexible exchange rate system. (4 marks)
- To restore the value of depreciating domestic currency, the central bank sells the US dollar in the international money market. True or false. (1 mark)
- ___ is said to occur when the exchange rate is increased by the official actions (government) under the fixed exchange rate system. (1 mark)
- Name the exchange rate when government fixes the exchange rate for the county. ( 1 mark)
- The managed floating exchange rate is determined by ____ and managed by the central bank. (1mark)
- Would the central bank need to intervene in a managed floating system? Explain why. (3 marks)
- Discuss briefly the meaning of (6 marks)
- Fixed exchange rate
- Flexible exchange rate
- Managed floating exchange rate
DEMAND FOR FOREIGN EXCHANGE: it refers to the outflow of foreign exchange that comes from those people who need it to make payment in foreign currency.
SOURCES FOR DEMAND OF FOREIGN EXCHANGE
- REPAYMENT OF INTERNATIONAL LOANS: international loans raise in terms of foreign currency. Accordingly, foreign currency is required for repaying this loan.
- FOREIGN INVESTMENT: investment in the rest of the world is vague (trend), we need the currency of the country in which investment is to be done.
- IMPORTS: every economy imports goods and services from the rest of the world to fulfill their domestic demand.
- DIRECT PURCHASES ABROAD/ TOURISM: foreign exchange is needed for direct purchases abroad because people from one country visit another country of the world as a tourist. They also go abroad for studies, for medical treatment which required a huge amount of foreign exchange.
- UNILATERAL TRANSFERS: grants and donations to the rest of the world also contribute to the demand for foreign exchange.
- SPECULATIVE TRADING: foreign exchange (particularly in terms of hard currency like the US dollar) is held by the people for speculative trading often, more foreign exchange is held when the exchange rate is low and visa-versa.
DEMAND CURVE OF FOREIGN EXCHANGE
- In the given diagram rate of foreign exchange is expressed on the x-axis and demand for foreign exchange on the y-axis.
- The demand curve DD is a negative slope curve representing that more of forex OQ1 is demanded at a low rate of exchange OR1, whereas, demand for forex falls to OQ2 when the exchange rate rises to OR2.
- Therefore demand curve of foreign exchange slopes downwards due to the inverse relationship between the demand of foreign exchange and the foreign exchange rate.
SUPPLY OF FOREIGN EXCHANGE: it refers to the inflow of foreign exchange that comes from the people who receive it.
SOURCES OF SUPPLY OF FOREIGN EXCHANGE
- EXPORTS: exports of goods and services is an important source of supply of foreign exchange from the rest of the world. For example, India exports tea, spices, etc. to the rest of the world and receives forex accordingly.
- INVESTMENT FROM ROW: investment from ROW in form of (FDI/FII) is another important source of supply. Underdeveloped economies receive a lot of forex from developed economies in form of this.
- LOANS FROM ROW: it refers to the borrowings from ROW. Underdeveloped countries generally encounter to develop in this situation the economy generally go with the borrowings.
- GRANTS AND DONATIONS FROM ROW: a significant amount of forex from rich to the poor countries of the world by the way of grants and donations.
- REMITTANCE FROM ABROAD: remittance by the NRI also an important source of supply from ROW by summing up to the aggregate supply of forex in the international money market.
SUPPLY CURE OF FOREIGN EXCHANGE RATE
- In the diagram rate of foreign exchange is shown on the y-axis and the supply of foreign exchange is shown on the x-axis.
- The positively sloped supply curve (SS) shows that the supply of foreign exchange raise from OQ1 to OQ2 when the exchange rate rises from OR1 to OR2.
- Therefore, the supply curve of foreign exchange slopes upwards due to the positive relationship between supply for foreign exchange and foreign exchange rate.
DETERMINATION OF FREE RATE OF EXCHANGE
- The free rate of exchange is determined by the interaction of forces (demand and supply)
- The equilibrium exchange rate is determined at a level where demand for foreign exchange and supply for foreign exchange is equal.
- Visits to foreign countries for sightseeing etc. by the people of India are on the rise. What will be its likely impact on the foreign exchange rate and how?
FOREIGN EXCHANGE MARKET
It is a market where foreign currencies are bought and sold
FUNCTIONS OF FOREIGN MARKET
- Transfers purchasing power between countries involved in the transaction.
- It provides credit for foreign trade.
- When exporters and importers agree to sell and buy goods on some future date at current prices. It is known as the hedging function.
KINDS OF FOREIGN MARKET
- Spot market: receipts and payment made immediately.
- Forward market: sale and purchase of foreign currency is settled through hedging function
- Define foreign market. Write its functions.
- Explain types of foreign markets.
DETERMINATION OF FORIEGN EXCHANGE RATE
The 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 supply for foreign exchange.
- In the diagram rate of exchange is shown on the x-axis and the demand and supply of foreign exchange are shown 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 the equilibrium quantity is determined at OQ.
Managed Floating Exchange Rate