4.

Foreign Exchange
Meaning : Exchange rate is that rate at which one unit of currency of s country can be exchanged for the
number of units of currency of another country. In other words it is the price paid in domestic currency in
order to get one unit of foreign currency, i.e. 1 $ = ₹ 79.
“Exchange rate is the price of the currency stated in terms of another currency.”

Fixed Exchange Rate : A system in which the government tries to peg the value of it’s currency to another
currency.

Merits/ Advantages of Fixed Exchange Rate

1. Avoid Currency Fluctuations : With a fixed exchange rate, your currency remains the same regardless of
how the market is performing. This means that you will be able to maintain your purchasing power regardless
of how the market is changing.

2. Encourages Investment/ Promotes Capital Formation : A fixed exchange rate system encourages
investment in the country by making it more stable than a floating rate system. A fixed rate system usually
means that the currency is pegged to another currency.
3. Keep Inflation under control : This prevents the country’s inflation from increasing and help to keep the
prices of goods and services affordable for citizens.

4. Exchange rate stability : Exchange rate stability, it is said , is necessary for orderly development of the
international economy and rapid growth of world trade.
5. Prevents Capital Outflow : A stable exchange rate ensures that such capital outflow would not occur.
6. Prevents speculation in foreign exchange market : The advocates of fixed exchange rate system points
out that the flexible and unstable exchange rate encourages speculation in foreign exchange market.
7. Promotes economic integration of the world : It has also been argued in favour of fixed exchange rate
system that is necessary for achieving economic integration of the community.
8. Promotes growth of internal money and capital market : Another big advantage of the fixed exchange
rate system is that it promotes growth of internal money and capital markets.

Demerits/ Disadvantages of Fixed Exchange Rate

1. Might hinder/ restrain macroeconomics objectives : The fixed exchange rate system has
been criticised for conflicts with other macroeconomics objectives, such as achieving
sustainable economic growth.
2. Less Flexibility : One of the disadvantage of a fixed exchange rate is that it limits the
country’s currency flexibility. The country imports more than it exports, which can leads to
financial problems.
3. Require higher interest rates : Fixed exchange rate requires higher interest rates to keep
the currency stable. It also makes it more expensive for people to purchase foreign goods.
4. Difficulty in keeping the value of the currency : The value of the currency will decline making imports
more expensive and exports cheaper. This can cause a major economic problem.
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Floating Exchange Rate : A floating Exchange Rate is regime where the currency price of a
nation is set by the forex market based on supply and demand relative to other currencies.
Merits/ Advantages of Floating Exchange
1. Automatic Stabilizing : Floating exchange rates are seen as an automatic stabilizer. The
appreciation of the currency makes the export less comparative and decrease them, thereby
reducing domestic output.
2. Absence of crisis : The possibility of international monetary crisis originating from
exchange rate changes automatically eliminated.
3. Free Internal Policy : A floating exchange rate allows a government to pursue internal
policy objective such as full employment growth in the absence of demand-pull inflation
without external constraints.
4. Avoiding Inflation : A floating exchange rate helps to insulate a country from inflation
elsewhere.
5. Low Reserve : Floating exchange rates should mean that there is hardly any need to
maintain large reserve to develop the economy.
6. Problem of undervaluation and overvaluation are avoided : The advocates of floating
exchange rates resist that under it the problem of undervaluation and overvaluation of
currencies which are found in the fixed exchange rate system are avoided.
7. Promotes growth of multilateral trade : The advocates of floating exchange rate system
are strangely of the view that as unlike fixed exchange rate system, this does not create
serious and difficult problems it will ensure rapid growth of multilateral trade.
8. It ensures Individual Freedom : The system of floating exchange rate is advocated on the
basis of philosophy that government should intervene in the economy as less as possible and
the individuals should be left free to pursue their economic interests.
Demerits/ Disadvantages of Floating Exchange Rate
1. Speculation : Exchange rate changes encourage currency speculation. The tendency to store foreign
exchange increases on the assumption that the exchange rate will depreciate.
2. Uncertainty : Fluctuating exchange rate creates uncertainty in international trade. It is not possible to
predict exactly how much income the exporters will get and how much the importers will incurr in this
transaction.
3. Decrease in investment : Uncertainty in international trade leads to decrease in investment in foreign
trade related industries. Due to this, the total employment in the country also decreases.
4. Adverse Terms of Trade: A flexible exchange rate policy makes the trade balance of some nations
unfavourable. Therefore, instead of benefiting from trade, the country loses.
5. Unaffordable for underdeveloped countries : The treatment of underdeveloped countries is always
unfavourable. In such a situation, if they adopt a floating exchange rate system, the balance of trade is
likely to become more unfavourable. Therefore, the floating exchange rate system is not affordable for
such countries.
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Purchasing Power Parity Theory
Purchasing power parity (PPP) is an economic theory of exchange rate determination. It states that the
price levels between two countries should be equal. This means that goods in each country will cost the
same once the currencies have been exchanged.
There are two versions of the purchasing power parity theory :
1. The Absolute Version 2. The Relative Version
1. The Absolute Version: According to this version of the purchasing power parity theory, the rate of
exchange should normally reflect the relation between the internal purchasing power of the different
national currency units. In other words, the rate of exchange equals to the ratio of outlay required to buy a
particular set or goods at own country’s market as compared with what it would be to buy in a foreign
country.
2. The Relative Version : According to this version, we take a base period and assume that the rate of
exchange between the two currencies was in equilibrium. And on this basis, the current equilibrium rate is
calculated by taking into account the shifts in price levels in the two countries.
For example, if in the base period, one dollar was equal to Rs.30, and then it is assumed to be the
equilibrium rate in that base period.
Further, compared with the base period rate, equilibrium exchange rate in the current period moves
against dollar with an increase in US prices and a fall in Indian prices, and vice versa.

Purchasing Power Parity Curve

The purchasing power parity curve is of a fluctuating character. It signifies a moving parity. Along with
it, the curves indicating commodity export and commodity import points also fluctuate. The market rate of
exchange is determined by the intersection of demand curve DD and supply curve SS of foreign exchange.

The market rate of exchange is OR and the quantity of foreign exchange demanded and supplied is
OQ. When the demand for and supply of foreign exchange change, the demand and supply curves can
undergo shifts as shown by D1 and S1 curves.
Accordingly, there will be variations in the market rate of exchange around the normal rate of
exchange determined by the purchasing power parity.