Foreign Exchange Rate

11.1: Meaning of Foreign Exchange Rate

- Foreign exchange refers to all currencies other than the domestic currency of the
given country.
- Ex: US Dollar, Kuwaiti Dinar, etc.
- 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.
- The exchange rate is determined by forces of demand and supply.

11.2: Currency Depreciation Vs Currency Appreciation

- Currency Depreciation refers to the decrease in the value of domestic currency in
terms of foreign currency. It makes domestic currency less valuable and more of
it is required to buy foreign currency
- Effect of Depreciation of Domestic Currency on Exports:
● If say the price of Indian Rupee (domestic currency) falls in terms of US
Dollar (foreign exchange)
● Then that means, that with the same amount of dollars, more goods can
be bought from India, ie., exports to USA will become relatively cheaper
- Currency Appreciation refers to the increase in the value of domestic currency in
terms of foreign currency. Domestic currency becomes more valuable and less of
it is required to buy the foreign currency.
- Effect of Appreciation of Domestic Currency on Imports:
● If say the price of Indian Rupee (domestic currency) rises in terms of US
Dollar (foreign exchange)
● Then that means, that with the same amount of rupees, more goods can
be bought from USA, ie., exports from USA will become relatively cheaper
11.3: Types of Foreign Exchange Rates
The three main types of exchange rate systems are:
1. Fixed Exchange Rate System (or Pegged Exchange Rate System):
- Referees to a system in which exchange rate for a currency in fixed by the
government
- To ensure stability in foreign trade and capital movements
- To achieve stability, govt. 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 the exchange rate at the level fixed
by it
- Under this system, each country keeps value of it’s 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 a currency is fixed in terms of some other 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 the ‘Parity Value’ of currency.
- Gold standard and Bretton Woods Standard:
● In earlier time, exchange rates of all major countries were fixed
according to the Gold Standard (1870-1914) and the Bretton
Woods Standard (1944-1971)
● According to the Gold Standard, external values of all currencies
were maintained by fixing their prices in terms of gold.
● According to Bretton Woods Standard, gold was replaced by the
US Dollar as the ‘core’ of the system. Under this system all
currencies were pegged or related to the US dollar at a fixed
exchange rate.
● This system gave birth to the International Monetary Fund as the
central institution in the international monetary system.
- Devaluation and Revaluation:
● Devaluation refers to reduction in the value of domestic currency of
the government and is said to occur when the exchange rate is
increased by the government under the Fixed Exchange Rate
System.
● Revaluation refers to an increase in the value of domestic currency
by the government.
● Devaluation vs Depreciation:
Basis Devaluation Depreciation

Meaning Devaluation refers to Depreciation refers to

the reduction in the fall in market price of
value of domestic domestic currency in
currency of the terms of a foreign
government and is currency under flexible
said to occur when the exchange rate regime
exchange rate is
increased by the
government under the
Fixed Exchange Rate

Occurrence It takes place due to It takes place due to

government market forces of
demand and supply
 Exchange rate system Under the fixed It takes place under
exchange rate system flexible exchange rate
system

2. Flexible Exchange Rate System (or Floating 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 the 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’
- Exchange rate is determined by the market, ie.e, through interaction of
thousands of banks, firms and other institutions seeking to buy and sell
currency for purposes of making transactions in foreign exchange.

Fixed Exchange Rate VS Flexible Exchange Rate

Basis Fixed Exchange Rate Flexible Exchange Rate

Determination of It is officially fixed in terms It is determined by forces

Exchange Rate of gold or other currency of demand and supply of
by government foreign exchange

Government control There is complete It is determined by forces

government control as only of demand and supply of
government has the power foreign exchange
to change it

Stability in Exchange The exchange rate The exchange rate keeps

Rate generally remains stable on changing.
and only a small variation
is possible

3. Managed Floating Rate System:

- It refers to a system in which foreign exchange rate is determined by
market forces and central bank influence the exchange rate through
intervention in the foreign exchange market
- The aim is to keep the 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

11.4: Demand for Foreign Exchange Rates

- 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. Imports of Goods and Services:
➔ Foreign Exchange is demanded to make the payment for imports of
goods and services
2. Tourism:
➔ Foreign exchange is needed to meet expenditure incurred in
foreign tours
3. Unilateral Transfers sent abroad:
➔ It 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 foreign countries.
5. Speculation:
➔ Demand for foreign exchange rises when people want to make
gains from the appreciation of currency.
- Reasons for ‘Rise in Demand’ for foreign currency:
1. When the price of a foreign currency falls, imports from that foreign
country becomes cheaper.
2. When a foreign currency becomes cheaper in terms of domestic currency
it promotes tourism to that country. As a result, demand for foreign
currency rises.
3. When the price of a foreign currency falls its demand rises as more people
want to make gains from speculative activities.
- Demand Curve of Foreign Exchange:
11.5: Supply of Foreign Exchange
- The supply (or inflow) of foreign exchange comes from those people who receive
it due to following reasons:
1. Exports of goods and services
2. Foreign investment
3. Remittances (unilateral transfers) from abroad
4. Speculation
- Reasons for ‘Rise in Supply’ of Foreign Currency:
➔ When the 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, the supply of foreign currency
rises.
➔ 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:

11.6: Determination of Exchange Rate

- The equilibrium exchange rate is determined at
a level where demand for foreign exchange is
equal to the supply of foreign exchange.
- Both the curves intersect each other at point ‘E’.
- The equilibrium exchange rate is determined at
OR and equilibrium is determined at OQ.

11.7: Changes in Exchange Rate

The equilibrium rate will be disturbed if some changes occur in the demand or supply of
foreign exchange
- Change in Demand:
Change in demand may either be:
 1. Increase in Demand
2. Decrease in Demand
- Change in Supply:
Changes in supply may either be:
1. Increase in supply
2. Decrease in supply

11.8: 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.
- Functions of Foreign Exchange Markets:
1. Transfer functions: 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
matters
2. Credit Functions: it provides credit for foreign trade
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 rates, 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 Markets:
1. Spot market: refers to the market in which receipts and payments are
made immediately
2. 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. 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.