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Foreign Exchange

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12 views

Foreign Exchange

Uploaded by

Ashwin Jaiswal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Ashwin’s Commerce World Ashwin’s Commerce World ASANSOL

FOREIGN EXCHANGE
Foreign currencies and claims on them in the form of bank deposits etc, payable in those currencies is known as
foreign exchange.
The foreign exchange market is the market where foreign exchange is traded.
Exchange rate refers to the rate at which currencies of different countries are traded or exchanged.

EXCHANGE RATE

FIXED FLOATING

CLEAN MANAGED/DIRTY

FIXED EXCHANGE RATE SYSTEM


1. In a fixed exchange rate system, the rate of exchange is officially fixed by the central bank or the government of
the country by official action.
2. Such a rate does not vary with the change in demand and supply of foreign currency.
3. The central bank buys foreign currencies at fixed exchange rate when there is excess supply of the foreign exchange
and sells it when there is excess demand of foreign exchange.
4. However fixed exchange rate system does not imply that the exchange rate remains absolutely fixed. Depending
on the circumstances and the state of economy, the rate of exchange is changed as a policy decision.

Floating exchange rate can be of two types: Clean floating or managed or dirty floating.

CLEAN FLOATING EXCHANGE RATE SYSTEM


1. In a Flexible or floating exchange rate system, exchange rate is left free to be determined in the foreign exchange
market by the forces of demand and supply of foreign exchange.
2. The central bank or the government do not control the rate of exchange.

MANAGED EXCHANGE RATE SYSTEM


In a system of managed floating or dirty floating, central bank intervenes to buy and sell foreign currencies in an
attempt to influence the exchange rate.
Normally, the action of central bank is to stabilize the exchange rate
IMPORTANT TERMS
1. Depreciation refers to a fall in the FREE MARKET VALUE of DOMESTIC CURRENCY in relation to currencies of other
countries in the foreign exchange market.
2. Appreciation means a rise in the FREE MARKET VALUE of DOMESTIC CURRENCY in relation to currencies of other
countries in the foreign exchange market.
3. Devaluation refers to an action UNDERTAKEN BY THE CENTRAL BANK to decrease the value of DOMESTIC
CURRENCY in relation to currency of other countries under a system of fixed exchange rates.
4. Revaluation refers to an action UNDERTAKEN BY THE CENTRAL BANK to raise the value of DOMESTIC CURRENCY in
relation to other currencies under a system of fixed exchange rates.

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Ashwin Jaiswal (9907-202-338) Ashwin’s Commerce World
Ashwin’s Commerce World Ashwin’s Commerce World ASANSOL

REASONS FOR THE DEMAND OF FOREIGN EXCHANGE: REASONS FOR THE SUPPLY OF FOREIGN EXCHANGE:
➢ Payment of loans and interest to international ➢ Refund of loans and interest from international
organisations. organisations.
➢ Gifts and grants to rest of the world. ➢ Gifts and grants from rest of the world.
➢ Foreign investments across the world. ➢ Foreign financing across the world.
➢ Import of goods. ➢ Export of goods.
➢ Growth of outbound tourism. ➢ Growth of inbound tourism.
➢ Foreign exchange trade for speculation. ➢ Foreign exchange trade for speculation.

DETERMINATION OF EXCHANGE RATE (FLOATING)

The flexible exchange rate is determined at a point where the demand for and supply of foreign exchanges are equal.
Figure illustrates determination of equilibrium exchange rate.

In the figure DD is the demand curve for foreign exchange. The DD curve is downward sloping showing inverse
relationship between price of foreign exchange implies lower demand for foreign exchange. The reason for this
relationship lies in the fact that rise in the price of foreign exchange will raise the rupee cost of foreign goals. This will
make the rupee cost of foreign goods more expensive. Consequently, imports will reduce and demand for foreign
exchange will fall.
SS is the supply curve of foreign exchange between exchange rate and supply of foreign exchange i.e. if exchange
increase, the supply of foreign exchange also increases. This will make domestic country’s goods cheaper to foreigners.
The demand for our exports will rise. It implies more supply of foreign exchange.
Point E is the point of equilibrium where demand and supply curves of foreign exchange intersect each other. It gives
equilibrium exchange rate in the foreign exchange rate in the foreign exchange market for US dollar.

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Ashwin Jaiswal (9907-202-338) Ashwin’s Commerce World

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