Foreign Exchange Rates

Foreign exchange rate is the price of one currency in terms of another

currency. For e.g.: one dollar = Rs.82, indicates that for every one dollar
India would have to spend Rs.82 and for every one dollar USA would get
Rs.82
Foreign exchange rate index is the price of one currency in terms of a
basket of other currencies, weighted according to their importance for the
countrys international transactions

https://youtu.be/bhmr4g-hvSE?si=8XoyC1oMJYT0rGxB
Fixed exchange rate is an exchange rate whose value is set at a particular
level in terms of another currency maintained by the government. This
might be a particular rate or a given margin
The central bank interferes in the market by buying or selling of the
foreign exchange currency in order to maintain the supply. They can also
change the interest rates in a country in order to change the purchasing
power/demand of the citizens for that foreign currency
Devaluation is a fall in the value of a fixed exchange rate
Devaluation happens when the country decreases the demand of the
foreign currency, therefore leaving excess supply in the market, reducing
the value of the currency
For e.g.: one dollar = Rs.82 is the fixed exchange rate. When there is a
shortage of demand for the dollar, it leads to excessive supply of the
dollar in the Indian market, therefore one dollar = Rs.72.
This indicates that lesser of rupees would have to be spent to acquire
that same one dollar.
The central government would interfere by doing the following:
1. Buying the Dollar: leading to a shortage of the dollar and thereby
maintaining the value of the dollar at one dollar = Rs.82
1. Increasing the interest rate (borrowing): this makes borrowing expensive
therefore reducing the purchasing power of citizens of India. Indians
have lesser rupees to buy the US dollar, making the US dollar less
precious in spite of excess supply
3. Increasing the interest rate (saving): this makes saving beneficial
therefore reducing the purchasing power of citizens of India. Indians
have less rupees to buy the US dollar, since majority of their money is
now being saved, therefore, making the US dollar less precious in spite
of excess supply
Price of rupees in dollars Price of rupees in dollars
S1
S S
D D
D1
D1

82 82
72

0 Q1 Q 0 Q1 Q Quantity of rupees
Quantity of rupees

1. Decrease in demand 1. Decrease in demand

2. Decrease in price 2. Decrease in supply
3. Less supply 3. New equilibrium
without decrease in
price
Revaluation is a rise in the value of a fixed exchange rate
Revaluation happens when the country increases the demand of the foreign
currency, therefore leaving shortage of supply in the market, increasing the
value of the currency
For e.g.: one dollar = Rs.82 is the fixed exchange rate. When there is an
excess of demand for the dollar, it leads to shortage supply of the dollar in
the Indian market, therefore one dollar = 92.
This indicates that more of rupees would have to be spent to acquire that
same one dollar.
The central government would interfere by doing the following:
1. Selling the Dollar: leading to an excess of the dollar and thereby
maintaining the value of the dollar at one dollar = Rs.82
1. Decreasing the interest rate (borrowing): this makes borrowing easier
therefore increasing the purchasing power of citizens of India. Indians
have more rupees to buy the US dollar, making the US dollar more
precious in spite of shortage supply
1. Decreasing the interest rate (saving): this makes saving less beneficial
therefore increasing the purchasing power of citizens of India. Indians
have more rupees to buy the US dollar, since majority of their money
is not being saved, therefore, making the US dollar more precious in
spite of shortage supply
Price of rupees in dollars Price of rupees in dollars
D1 S D1 S
D D S1

92
82 82 -

0 Q Q1 0 Q Q1 Quantity of rupees
Quantity of rupees

1. Increase in demand 1. Increase in demand

2. Increase in price 2. Increase in supply
3. More supply 3. New equilibrium
without increase in
price
Floating exchange rate is an exchange rate which can change frequently as
it is determined by market forces and is not pre-decided
The demand and supply of a foreign currency in a market is directly
related to the valuation of their foreign currency in terms of the home
currency.
Depreciation is a fall in the value of a floating exchange rate
If the demand for the US dollar falls in India or the supply of the US
dollar rises in India, the price of the US dollar in Indian rupees will
depreciate.
For e.g.: one dollar = Rs.82 will now become one dollar = Rs.72 due to
lack of demand or excessive supply, making the US dollar less precious,
therefore, reducing its value
Price of rupees in dollars
S
D
D1

82
72

0 Q1 Q Quantity of rupees
Appreciation is a rise in the value of a floating exchange rate
If the demand for the US dollar rises in India or the supply of the US
dollar falls in India, the price of the US dollar in Indian rupees will
appreciate.
For e.g.: one dollar = Rs.82 will now become one dollar = Rs.92 due to
excessive of demand or lack supply, making the US dollar more precious,
therefore, increasing its value
Price of rupees in dollars
D1 S
D

92
82

0 Q Q1 Quantity of rupees
Depreciation of the dollar against INR = less rupees are required to buy
the Dollar/more can be bought with the same amount of dollars
Therefore one dollar was = Rs. 82. Now it is one dollar = Rs. 72
Depreciation of INR against the dollar = more rupees are required to buy
the dollar/less good can be bought by the same amount of dollars
Therefore one dollar was = Rs. 82. Now it is one dollar = Rs. 92
Appreciation of the dollar against INR = one dollar was = Rs. 82. Now it is
one dollar = Rs. 92
Appreciation of INR against the dollar = one dollar was = Rs. 82. Now it is
one dollar = Rs. 72
Reasons to sell foreign currency / buy Indian rupees:
1. Speculation of a decrease in the value of a foreign currency (selling)
2. Demand for exports from India by foreigners
3. Buy of financial assets from India
4. Foreign direct investment by foreign MNCs into India
5. Foreign-based Indian MNCs sending profits back to India
6. Foreign banks buying Indian currencies for their customers
7. Foreign banks paying interest to Indian citizens abroad
8. Foreign firms paying dividends to Indian residents
9. Workers remittances from Indians working abroad
10. Foreign firms wishing to buy Indian firms and set up units in India
11. Foreign firms and individuals investing in Indian companies
12. Foreign firms and individuals saving in Indian banks
13. Foreign firms and individuals lending to Indian firms and individuals
14. Foreign government holding rupees as a reserve currency
15. Speculators expecting a rise in rupees
Reasons to buy foreign currency / sale of Indian rupees:
1. Speculation of an increase in the value of a foreign currency (buying)
2. Demand for foreign imports from abroad by Indians
3. Purchase financial assets from abroad
4. Foreign direct investment by Indian MNCs abroad
5. Foreign based MNCs in India are sending profits back to their nation
6. Indian banks buy foreign currencies for their customers
7. Indian banks paying interest to foreign citizens in India
8. Indian firms paying dividend to foreign citizens
9. Workers remittances from foreign workers working in India
10. Indian firms wishing to buy foreign firms and set up units abroad
11. Indian firms and individuals investing in companies abroad
12. Indian firms and individuals saving in banks
13. Indian firms and individuals lending to foreign firms and
14. Indian government holding foreign currency as a reserve
15. Speculators expecting a rise in the value of a foreign currency
A rise in the rate of interest in Indian banks encourages foreigners to place
money in Indian banks, and hence the demand for rupees rises, they saw
the price of rupees in terms of the US dollar increases. Originally, one dollar
= Rs.82, well now become one dollar = Rs.92

Price of rupees in dollars

D1 S
D

92
82

0 Q Q1 Quantity of rupees
Causes of exchange rate fluctuations:
1. Export revenue exceeds import expenditure = rise in demand of the
currency = appreciation
2. Increase in investment from a foreign MNC setting up in the country
= rise in demand of the currency = appreciation
3. Purchase of asset from the country = rise in demand of the currency
= appreciation
4. Rise in price of a currency / appreciation = increase in demand by
speculators = appreciation
Government and central bank influence on floating exchange rate :
1. Buying the foreign currency = appreciation = rise in price due to lack
of supply
2. Raise interest rates = attract new investments / hot money flows =
demand rises = appreciation
3. Measures to increase exports and reduce imports = appreciation
Consequences of a change in exchange rate:
1. Appreciation of currency (appreciation of INR) = higher price for
exports (more money will have to be spent by people abroad to
acquire our country products) and lower price for imports (less money
will be spent by us to acquire products from abroad)
For e.g.: initially one dollar = Rs.82. Therefore an Indian export valued at
Rs.820 would sell in USA for 10 dollars. At the same time an import from
the USA valued at dollars 20 would sell in India for Rs.1640.
Appreciation of the INR against USD = more USD must be spent to
acquire the same amount of INR = one dollars = Rs. 41
Export of Indian product of Rs. 820, sold for 10 dollars previously, is now
worth 20 dollars
Import of American product of dollars 20, bought previously for Rs. 1640,
is now bought by India for Rs. 820
Rise in export prices = fewer exports = less revenue from abroad (elastic
demand)
Rise in export prices = similar exports = increase revenue from abroad
(inelastic demand)
Rise in import prices = less imports = less expenditure abroad
2. Depreciation of currency (depreciation of the INR) = lower price for
exports (less money will have to be spent by people abroad to acquire
our country products) and more price for imports (more money will be
spent by us to acquire products from abroad)
For e.g.: initially one dollar = Rs.82. Therefore an Indian export valued at
Rs.820 would sell in USA for 10 dollars. At the same time an import from
the USA valued at dollars 20 would sell in India for Rs.1640.
Depreciation of the INR against USD = less USD must be spent to acquire
the same amount of INR = one dollars = Rs. 164
Export of Indian product of Rs. 820, sold for 10 dollars previously, is now
worth only 5 dollars
Import of American product of dollars 20, bought previously for Rs. 1640,
is now bought by India for Rs. 3280
Fall in export prices = more exports = more revenue from abroad (elastic
demand / inelastic demand)
Rise in import prices = less imports = less expenditure abroad
3. Depreciation of exchange rate = low export prices / high import
prices = increased demand for domestic products = increase in aggregate
demand = increase in output = increase in employment (unless operating at
full capacity)

Price level
AD1 AS
AD

P1
P

AD1 = C + I + G + (X - M1)
AD = C + I + G + (X - M)

0 Y Y1 Real GDP
4. Depreciation of exchange rate = increase in inflationary pressure due
to:
Expensive raw material = expensive cost of production = expensive
finished product
Reduced pressure on domestic firms to keep low price since there is no
such requirement to remain competitive = higher price for consumers
Advantages of a floating exchange rate:
1. Helps to eliminate the gap between export revenue and import
expenditure
2. Rise in imports + fall in exports = rise in supply of the currency = fall
in demand for the currency = depreciation of the currency = reduction in
export prices + rise in import prices = balanced export revenue and import
expenditure
Although, if individuals believe in economic prospects being good, they will
still continue to demand the currency
Nevertheless, government can concentrate on other objectives as they do
not have to keep reserves for foreign currency to influence its value
Disadvantages of a floating exchange rate:
1. Constant fluctuations make it difficult to plan
2. Speculations may cause constant changes
3. A large depreciation = a large rise in the countrys inflation rate

Advantage of a fixed exchange rate:

1. Create certainty
2. Helps future planning for firms and individuals
Disadvantage of a fixed exchange rate:
1. Considerable usage of reserve to maintain foreign currency by
central bank
2. Implementation of policies by central bank interfering with other
government objectives. For e.g.: rise in rate of interest by central
government to reverse the valuation = unemployment and slow economic
growth due to less aggregate demand
3. Constant changing in prices to maintain exchange rate = loss of
confidence
A country is called internationally competitive if the goods and services
provided by the country a desired by the consumers at an acceptable price
Indicators of international competitiveness:
1. Economic growth rate (stable)
2. Share of world trade (reasonable)
3. Expenditure on research and development (high)
4. Quantity and quality of education and training (good)
5. Infrastructure of the country (developed)
Short run = fall in exchange rate and inflation = more attractive products
Long run = changes in productivity may cause serious problems