FOREIGN EXCHANGE RATE
Foreign exchange refers to all currencies other than the domestic currency of given country.
Foreign exchange rate refers to the rate at which one currency is exchanged for the other. For example if $1 can be exchanged for Rs60, then value of Rs1 will be
Rs 1= 1/60 =.0167$
Currency depreciation refers to decrease in the value of domestic currency in terms of foreign currency. It makes the domestic currency less valuable and more of it is required to buy the foreign currency. For example rupee is said to be depreciating if price of $1 rises from rs 55 to rs 60.
Effects of depreciation of domestic currency on exports- depreciation of domestic currency (say, rupee) in terms of a foreign currency (say $). It means with same amount of dollars, more goods can be purchased from India, i.e. exports to USA will increase as they will becomes relatively cheaper.
Currency appreciation refers to increase in the value of domestic currency in terms of foreign currency. The domestic currency becomes more valuable and less of it is required to buy the foreign currency. For example Indian rupee appreciates when price of $1 falls from rs 60 to 55.
Effect of appreciation of domestic currency mean a rise in the price of domestic currency(say rupee)in terms of a foreign
currency (say $). Now , one rupee can be exchanged for more $ i.e. same amount of money, more goods can be purchased from USA. It leads to increase in imports from USA as American goods will become relatively cheaper.
Type of Foreign Exchange rates –
1. Fixed exchange rate system ( or Pegged exchange rate system)- refers to a system in which exchange rate for a currency is fixed by the government.
2. Flexible exchange rate system – refers to system in which
exchange rate is determined by forces of demand and supply of different currencies in the foreign exchange market.
3. Managed floating rate system – refers to a system in which foreign exchange rate is determined by market forces and
central bank influences the exchange rate through intervention in the foreign exchange market.
Devaluation refers to reduction in the value of domestic currency by the govt. Devaluation is said to occur when the exchange rate is increased by the govt. under fixed exchange rate system. On the other revaluation refers to increase in the value of domestic
currency by the govt.
Demand for foreign exchange- the demand or outflow of foreign exchange comes from those people who need it to make payment in foreign currency. It demanded by the domestic residents for following reasons:
1. Imports of goods/services – foreign exchanged is demanded to make the payment for g/s.
2. Tourism – foreign exchange is needed to meet expenditure incurred in foreign tours.
3. Unilateral transfer sent abroad – foreign exchange 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 the foreign countries.
5. Speculation – Demand for foreign exchange arises when people want to make gain from appreciation of currency.
Reasons for rise in demand for foreign currency
1. When price of a foreign currency falls, imports from that foreign country become cheaper. So, imports increase and hence, the demand for foreign currency rises.
2. When a foreign currency become cheaper in terms of the domestic currency ,it promotes tourism to that country. As a result ,demand for foreign currency rises.
3. When price of a foreign currency falls, its demand rises as more people want to make gains from speculative activities.
Demand curve of foreign exchange – it curve slope downwards due to inverse relationship between demand for foreign
exchange and foreign exchange rate.
Supply of foreign exchange-
1. Exports of goods and services – supply of foreign exchange comes through exports of g/s.
2. Foreign investment – the amount which foreigners invest in the home country, increase the supply of foreign exchange.
3. Remittances (unilateral transfers) from abroad – supply of foreign exchange increases in the form of gift and other remittances from abroad.
4. Speculation – supply of foreign exchange comes from those who want to speculate on the valued foreign exchange.
Reasons for rise in supply of foreign currency-
1. When supply of foreign currency rises, domestic goods
relatively cheaper. It induces the foreign country to increase their imports from the domestic country.
2. 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 – supply curve of foreign exchange slope upwards due tom positive relationship
between supply of foreign exchange and foreign exchange
Determination of Exchange Rate – Flexible exchange rate id determined by the interaction of the forces of demand and supply. The equilibrium exchange rate is determined at a level where demand for foreign exchange is equal to the supply of foreign exchange.
Change in Exchange Rate – the equilibrium exchange rate will be disturbed if some changes occur in the demand or supply of foreign exchange.
1. Change in demand
increase in demand
decrease in demand 2. Chang in supply
Increase in supply
Decrease in supply
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. Foreign exchange market is a system ,not a place.
In this market large number of foreign currency are traded, converted, and exchanged.
Functions of foreign exchange market
1. Transfer function – it transfers purchasing power between the countries involved in the transaction.
2. Credit function – 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 rate, it is called hedging.
Kinds of foreign exchange markets – foreign markets are classified on the basis of whether the foreign exchange transactions are spot or forward .
1. Spot market – refers to market in which the 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 agreed upon today .
X---X
X
