The importing country pays money to the exporting country in return of goods either in its domestic currency or the hard currency. This currency which facilitates the payment to complete the transaction is called foreign exchange. This foreign exchange is the money in one country for money or credit or goods or services in another country. Foreign exchange includes foreign currency, cheques and foreign drafts. ` Foreign exchange is bought and sold in foreign exchange markets. The components of foreign exchange market rate include: the buyers, the sellers and the intermediaries. The market intermediaries of foreign exchange market include Exchange banks dealing in foreign exchange, bill brokers, acceptance houses and Central Bank of the country.
Exchange rate determination:
The transactions in the foreign exchange market, viz., buying and selling foreign currency take at a rate which is called exchange rate. Exchange rate is the price paid in the home currency for a unit of foreign currency. The exchange rate can be quoted in two ways namely
One unit of foreign money to a number of units of domestic currency.
A certain number of units of foreign currency to one unit of domestic country.
For example, 1 US$ = Rs.48 or Rs. 1 = US$ 0.02
Exchange rate in a free market is determined by the demand and the supply of exchange of a particular country. The equilibrium exchange rate is the rate at which demand for foreign exchange and the supply of foreign exchange are equal. Equilibrium exchange rate can be determined by two methods:
The Exchange rate between US dollars and Indian Rupees can be determined by demand for and supply of US dollars in India or by Indians. The price of US $ is fixed in Indian Rupees.
The exchange rate between Indian Rupees and US $ dollars can also be determined by demand for and supply of Indian Rupees by Americans or in USA. The price of Indian Rupee is determined in US dollars. But the prices are same in both these methods.
Demand for Foreign Exchange: The demand for foreign exchange is determined by the country’s
Import of goods and services
Investment in foreign countries i.e. establishment of an industry by Indians in USA.
Other payments involved in international transactions like payments of Indian Government to various foreign governments for settlement of their transactions.
Other types of foreign capital like giving donations etc.
Supply of Foreign Exchange: Supply of Foreign Exchange of a particular country indicates the availability of foreign currency of a particular country to the country concerned (i.e. India) in its foreign exchange market. The supply of foreign exchange includes:
Country’s exports of goods and services to foreign countries.
Inflow of foreign capital
Payments made by the foreign governments to Indian governments for settling their transactions.
Other types of inflow of foreign capital like remittances by the Non-Resident Indians, donations received etc.
EXCHANGE RATE SYSTEM:
Fixed Exchange Rates:
Under this system, the governments used to fix the exchange rate and the central bank to operate it by creating ‘exchange establishment fund’. The central bank of country purchases the foreign currency when the exchange rate falls and sells the foreign exchange when the exchange rate increases. The countries follow fixed exchange rates due to its advantages. They are:
Fixed exchange rates ensure certainty and confidence and thereby promoters international business.
Fixed exchange rates promote long-term investments by various across the globe.
Most of the world currency like US dollar areas and sterling pound areas prefer fixed exchange rates.
Fixed exchange rates result in economic stabilization.
Fixed exchange rates stabiles international business and avoid foreign exchange risks to a greater extent. As such the small but international business oriented countries like UK and Demark prefer fixed exchange rate system.
Despite these advantages, most of the world countries at present are not in favour of this system because of the following reasons;
Due to problems with the fixed exchange rate system, IMF permits occasional changes in the system. The system is changed into managed flexibility system. The managed flexibility system needs large foreign exchange reserves to buy or sell foreign exchange in order to manage the exchange rate. Maintenance of greater reserves aggravate the problem of international liquidity.
Fixed exchange rates system may result in a large scale destabilizing speculation in foreign exchange markets.
Long-term foreign capital may not be attracted as the exchange rates are not pegged permanently.
The economic policies and foreign exchange policies of the countries are rarely coordinated. In such case, the exchange rate system does not work.
Most of the economies in recent years are liberalized and globalize. These economies prefer flexible exchange rate system.
Deficit of balance of payments of most of the countries increases under fixed exchange rate system as the elasticities in international markets are too low for exchange rate exchanges.
Flexible Exchange Rates:
Flexible exchange rates are also called floating or fluctuating exchange rates. Flexible exchange rates are determined by market forces like demand for and supply of foreign exchange.
Either the government or monetary authorities do not interfere or intervene in the process of exchange rate determination. Under this system, if the supply of foreign exchange is more than that
of demand for the same, the exchange rate is determined at a low rate and vice versa. Most of the countries in recent times are in favour of flexible exchange rates due to their advantages.
This system is simple to operate. This system does not result in deficit or surplus of foreign exchange. The exchange rate moves automatically and freely.
The adjustment of exchange rate under this system is a continuous process.
The system helps for the promotion of foreign trade.
Stability in exchange rate in the long-run is not possible even in fixed exchange rate system.
Hence, this system provides the same benefit like fixed exchange rate system for long term investments.
This system permits the existence of free trade and convertible currencies on a continuous basis.
This system also confers more independence on the government regarding their domestic policies.
This system eliminates the expenditure of maintenance of official foreign exchange reserves and operation of the fixed exchange rate system.
Disadvantages:
However this system is also not free from the disadvantages. The disadvantages of this system include:
Market mechanism may fail to bring about an appropriate exchange rate. The equilibrium exchange rate may fail to give correct signals to correct the balance of payments position.
It is rather difficult to define flexible exchange rate.
Under flexible exchange rate system, the exchange rate changes quite frequently. These frequent changes result in exchange risks, breed uncertainty and impede international trade and capital movements.
Under flexible rate system, speculation adversely influences fluctuations in supply and demand for foreign exchange.
Under this system a reduction in exchange rates leads to a vicious circle of inflation.
Despite the advantages of fixed exchange rate and the disadvantages of floating exchange rate system, it is viewed that the flexible rate system is suitable for the globalization process. In addition,
the convert ability also helps the floating rate system and the globalization of foreign exchange process.