Foreign Exchange Rate

EXPLAIN MEANING OF FOREIGN EXCHANGE RATE

  1. Foreign exchange rate is the price of a currency expressed in terms of another currency. Some economists refer to it as the external value of the currency.
  2. Foreign Currency : It refers to all currencies other than the domestic currency of a given country. e.g., India’s domestic currency is Indian Rupees and all other currencies like US Dollar, British Pound etc. are foreign exchange.

For example, if an American firm exports goods to India, it would like to receive the payment in Dollars. As a result, Indian importers will have to convert Indian Rupees into American Dollars to make the payment.

It creates the problem of converting one currency into another and fixing the rate at which the two currencies are to be exchanged. In fact, it is the problem of the determination of foreign exchange rate. Foreign Exchange Rate refers to the rate at which one currency is exchanged for the other. It represents the price of one currency in terms of another currency.

For example: If $ 1 can be exchanged for Rs. 60, then the value of Rs. 1 will be :

                                                             Rs.1       $  0.167$

TYPES OF FOREIGN EXCHANGE RATE

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

Q. Define fixed exchange rate?

Fixed rate of exchange refers to the rate of exchange that is officially declared and is fixed by the government. The basic purpose of adopting this system is to ensure stability in foreign trade and capital movement.

Fixed Exchange Rate System

A fixed exchange rate system refers to a system in which the 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 a reduction in the value of the 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 an increase in the value of the domestic currency by the government.

Devaluation Vs Depreciation

BasicDevaluationDepreciation
MeaningDevaluation refers to a reduction in the price of domestic currency in terms of all foreign currencies under a fixed exchange rate regime.Depreciation refers to the tall in the market price of domestic currency in terms of a foreign currency under a flexible exchange rate regime.
OccurrenceIt takes place due to Government.It takes place due to market forces of demand and supply.
Exchange RateIt takes place under a fixed exchange rate system.It takes place under a flexible exchange rate system
[Foreign Exchange Rate]

Q. Define Flexible Exchange Rate?

A flexible exchange rate system refers to a system in which the 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 institution seeking to buy and sell currency for purposes of making transactions in foreign exchange.

MERITS AND DEMERITS OF FLEXIBLE EXCHANGE RATE SYSTEM

Merits

  1. Maintains Equilibrium Level : Flexible exchange rate is self-adjusting and automatically removes the disequilibrium in the balance of payments (BOP). It eliminates the problems of overvaluation and undervaluation of currencies.
  2. Noneed for Huge Foreign Exchange reserves : There is no need for the government to hold large foreign exchange reserves. It enhances the movement of capital across different parts of the world and promotes international growth.
  3. Optimum Utilisation of Resources : It provides the opportunity for optimum utilisation of resources and raises the level of efficiency in the economy.

Demerits

  1. Instability in the Exchange Rate : The external Value of domestic currency keeps on changing as per demand and supply of foreign exchange. It creates uncertainty ab out the amount of receipts and payments in foreign exchange transactions. Such instabilities hamper foreign trade.
  2. Speculative Activities :  Speculators manipulate the market and make the exchange rates too low or too high. This makes the foreign exchange market unstable and discourages foreign trade and foreign investments.
  3. Creates inflationary Situation : It generates inflationary trends in the economy, when there is increase in the prices of imports due to depreciation of the economy.

Fixed Exchange Rate Vs Flexible Exchange Rate

BasisFixed Exchange RateFlexible Exchange Rate
DeterminationIt is officially fixed in termsIt is determined by forces of
of Exchangeof gold or any other currencydemand and supply of foreign
Rateby government.exchange.
GovernmentThere is complete governmentThere is no government
[Foreign Exchange Rate]
Controlcontrol as the only governmentintervention and it fluctuates
 has the power to change it.freely according to market conditions.
Stability inThe exchange rate generallyThe exchange rate keeps on
Exchangeremains  stable and only achanging.
Ratethe small variation is possible. 
[Foreign Exchange Rate]

Q. Define Managed Floating

It refers to a system in which the foreign exchange rate is determined by market forces and the 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’.

Q. Define Managed Floating

It refers to a system in which the foreign exchange rate is determined by market forces and the 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’.

Q. Distinguish between Currency Depreciation Vs Currency Appreciation?

Currency Depreciation

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

Example: Rupee is said to be depreciating if the price of $1 rises from Rs. 55 to Rs. 60

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, one $ can be exchanged for more rupees, i.e., with the same amount of dollars, more goods can be purchased from India.  It means exports to the USA will become relatively cheaper.

It leads to an increase in exports to the USA.

Currency Appreciation

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

For example, Indian rupees appreciate when the price of $1 falls from Rs. 50 to Rs 45.

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 the same amount of money more goods can be purchased from the USA.  It means imports from the USA will become relatively cheaper. It leads to an increase in imports from the USA.

BasisCurrency Depreciation Currency Appreciation
MeaningIt refers to a decrease in theIt refers to an increase in the value
 value of the domestic currency inof domestic currency in terms
 terms of foreign currency.of foreign currency.
Effect onIt makes domestic goodsIt makes foreign goods cheaper
imports/Exportscheaper in a foreign country asin the domestic country as more of
[Foreign Exchange Rate]
 more of such goods can nowsuch goods can now be
 be purchased with the samethe same amount of domestic
 amount of foreign currency.currency. So, it leads to
 So, it leads to an increase in exports.increase in imports.
ExampleA change from $1 = Rs. 55 toA change from $1 =Rs. 60 to
 Rs.1 = Rs. 60 represents that$1 = Rs. 55 represents that
 Indian Rupees is depreciating.Indian Rupees is appreciated.
[Foreign Exchange Rate]

Q. Explain the source of Demand for Foreign Exchange.

Ans. Demand or outflow for foreign exchange arises due to the following reasons.

  1. Imports of goods and servides : Foreign Exchange is demanded to make the payment for imports of goods and servides.
  2. Tourism : When Indian tourists go abroad, they need to have foreign currency with them to meet their expenditure abroad. So, foreign exchange is needed to undertake 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 pyament for purchased 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.

Q. Explain Relationship between Price Foriegn Exchange Rate and Demand for Foreign Exchange.

Ans. There is an inverse relationship between the price of foreign exchange and the demand for that foreign exchange in terms of the domestic currency.

The higher the price, the lower is the demand for foreign exchange, and the lower the price the higher is the demand. For example, the higher the price of the US dollar in India, the lower is likely to be its demand. Suppose the present price of the US dollar is ˆ 50. It means that to buy one dollar worth of goods from the U.S.A., India has to part with ˆ 50. Suppose the price falls to ˆ 40 a dollar. It means that now India has to part with ˆ 40 to buy one US dollar worth of goods. It also means that American goods have now become cheaper because it now takes fewer rupees to buy.


Foreign Exchange Rate

Leave a Comment