Class 12 Macroeconomics

Foreign Exchange & Foreign

Exchange Rate
 Foreign exchange refers to all currencies other than the
Foreign domestic currency of a given country.
 For example : India's domestic currency is the Indian rupee

Exchange
and all other currencies like US Dollar, British Pound, etc. are
foreign exchange.

Foreign  The foreign exchange rate refers to the rate at which one
currency is exchanged for the other. It represents the price of one

Exchange currency in terms of another currency.

 For example : If $1 can be exchanged for Rs 78, then the value of
Rs 1 will be
Rate : Rs 1 = 1/78 $ = 0.128 $.
Currency Depreciation

Current depreciation refers to the decrease in

the value of the 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 depreciate if the

price of $1 rises from Rs 77 to Rs 79.
Effect of Depreciation of Domestic Currency on Exports

Deprecation of domestic currency

means a fall in the price of domestic
currency in terms of foreign
currency.

It means, with the same amount of

dollars, more goods can be
purchased from India, i.e. exports to
the USA will increase as they will
become relatively cheaper.
Currency Appreciation

Currency appreciation refers to an increase in the

value of the 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, the Indian rupee appreciates when

the price of $1 falls from Rs 79 to Rs 77.
Effect of Appreciation of Domestic Currency on Imports

Appreciation of domestic currency means

a rise in the price of domestic currency in
the terms of foreign currency

Now, one rupee can be exchanged for

more $, i.e., with the same amount of
money, more goods can be purchased
from the USA

It leads to an increase in imports from the

USA as American goods will become
relatively cheaper.
Differences Between Currency Depreciation & Currency Appreciation

Basis Currency Depreciation Currency Appreciation

It refers to the decrease in the It refers to an increase in the
Meaning value of the domestic currency value of the domestic currency in
in terms of foreign currency. terms of foreign currency.
It makes domestic goods
It makes foreign goods cheaper in
cheaper in foreign countries as
Effect on more such goods can now be domestic countries as more such
goods can now be purchased with
Imports / purchased with the same the same amount of domestic
Exports amount of foreign currency. So, currency. So, it leads to an
it leads to an increase in
increase in imports.
exports.

A change from $1 = Rs 77 to $1 = A change from $1 = Rs 79 to $1 = Rs

Example Rs 79 represents that the Indian 77 represents that the Indian
rupee is depreciating. rupee is appreciating.
Types of Foreign Exchange Rates are :

Fixed Exchange Rates System

(Pegged Exchange Rate)

Flexible Exchange Rates System

(Floating Exchange Rate)

Managed Floating Rate

System
 Fixed Exchange Rate System

1 A fixed exchange rate system refers to a system in which

the exchange rate for a currency is fixed by the government.

2 The basic purpose of adopting this system is to ensure stability in

foreign trade and capital movements.

3 Under this system, each country keeps the value of its currency fixed in
terms of some „External Standard‟.

4 When the value of the domestic currency is tied to the value of another
currency, it is known as 'pegging’.

5 When the value of a currency is fixed in terms of some other currency

or terms of gold, it is known as the ‘Parity Value’ of currency.
 Flexible Exchange Rate System

1 A flexible exchange rate system refers to a system in which the exchange rate is
determined by forces of demand and supply of different currencies in the foreign
exchange market.

2 The value of a currency is allowed to fluctuate freely according to changes

in the demand and supply of foreign exchange.

3 There is no official (government) intervention in the foreign exchange

market.

4 The exchange rate is determined by the Market, i.e. through interactions of

thousands of banks, firms, and other institutions seeking to buy and sell currency for
purposes of making transactions in foreign exchange.

5 It is also known as the 'Floating Exchange Rate'.

 Managed Floating Rate System

1 It refers to a system in which the foreign exchange rate is determined by market

forces and the central bank influences the exchange rate through intervention
in the foreign exchange market.

2 It is a hybrid of a fixed exchange rate and a flexible exchange rate system.

3
In this system, the central bank intervenes in the foreign exchange market to restrict
the fluctuations in the exchange rate within certain limits. The aim is to keep the
exchange rate close to desired target values.

4 For this, the central bank maintains reserves of foreign exchange

to ensure that the exchange rate stays within the targeted value.

5 It is also known as „Dirty floating‟.

 Devaluation It refers to the reduction in the value of the domestic currency by the government.

Revaluation It refers to an increase in the value of the domestic currency by the government.

Differences between Devaluation & Depreciation of Domestic Currency

Basis Devaluation Depreciation
Devaluation refers to the reduction Depreciation refers to a fall in the
in the price of domestic currency in market price of domestic currency in
Meaning
terms of all foreign currencies under terms of a foreign currency under a
a fixed exchange rate regime. flexible exchange rate regime.

It takes place due to the It takes place due to market

Occurrence government. forces of demand and supply.

Exchange
It takes place under a fixed It takes place under a flexible
Rate
exchange rate system. exchange rate system.
System
Difference Between Fixed Exchange Rate & Flexible Exchange Rate System.

Fixed Exchange Flexible Exchange

Basis
Rate Rate
It is officially fixed in
Determination It is determined by forces of
terms of gold or any
of Exchange demand and supply of
other currency by the
Rate foreign exchange.
government.

There is complete There is no government

Government government control as intervention and it
Control only the government has fluctuates freely according
the power to change it. to the market conditions.

The exchange rate

Stability in the
generally remains stable The exchange rate keeps on
Exchange
and only a small changing.
Rate variation is possible.
When the Demand for Foreign Currency Arises
Import of Goods & Services
Foreign exchange is determined to make the payment for imports of goods and services.

Tourism
Foreign exchange is needed to meet expenditures incurred in foreign tours.

Unilateral Transfers Sent Abroad

Foreign exchange is required for making unilateral transfers like sending
gifts to other countries.

Purchase of Assets in Foreign Countries

It is demanded to make payment for the purchase of assets, like land, shares, bonds, etc. in the
foreign countries

Speculation
Demand for foreign exchange arises when people want to make gains from the appreciation of
the currency.
 Reasons for the Rise in
Demand for Foreign
Currency

When the price of a foreign currency falls, imports from that foreign country become
cheaper. So, imports increase and hence, the demand for foreign exchange rises

For example : if the price of 1 US dollar falls from Rs 79 to Rs 77, then imports from the
USA will increase as American goods will become relatively cheaper. It will raise the
demand for US dollars.

When a foreign currency becomes cheaper in terms of domestic currency, it promotes

tourism to that country, which raises the demand for foreign currency.

When the price of a foreign currency falls, its demand rises as more people want to make
gains from speculative activities.
 Demand for Foreign Exchange with the Help of a Curve

The demand curve of foreign exchange slopes downwards

due to the inverse relationship between demand for
foreign exchange rate and foreign exchange rate.

Y
Demand Curve of Foreign Exchange Explanation :
D
 In the above figure, demand for foreign
(Price of Dollar in terms of ₹)
Rate of Foreign Exchange

R2 B
exchange (US Dollar) and the rate of
R1
A
foreign exchange are shown on the X-axis
D
and Y-axis respectively.
X
 The negatively sloped demand curve (DD)
O Q2 Q1
Demand for Foreign Exchange
shows that more foreign exchange (OQ1), is
(in Dollars)
demanded at a low exchange rate OR1.
When the Supply for Foreign Exchange Arises
Export of Goods & Services
Supply of foreign exchange comes through exports of goods and services.

Foreign Investment
The amount foreigners invest in their home country increases the supply of
foreign exchange.

Remittances (Unilateral Transfers) from Abroad

Supply of foreign exchange increases in the form of gifts and other remittances from abroad.

Speculation
Supply of foreign exchange comes from those who want to speculate on the
value of foreign exchange.
 Reasons for „Rise in
Supply‟ of Foreign
Currency

 When the price of foreign currency rises, domestic goods become relatively
cheaper.
It includes the foreign country increasing their imports from the domestic
country. For example : if the price of 1 US dollar rises from Rs 77 to Rs 79, then
exports to the USA will increase as Indian goods will become relatively
cheaper. It will raise the supply of US dollars.

 When the price of foreign currency rises, the supply of foreign currency
rises as people want to make gains from speculative activities.
 Supply of Foreign Exchange with Help of Curve
The supply curve of foreign exchange slopes upwards
due to a positive relationship between the supply for
foreign exchange and foreign exchange rates.
Y

Supply Curve of Foreign Exchange

Explanation :
S
 In the above figure, the supply of foreign
(Price of Dollar in terms of ₹)
Rate of Foreign Exchange

R2
B
exchange (US Dollars) and rate of foreign
exchange have been shown on the x-axis
and y-axis respectively.
R1 A

 The positively sloped supply curve (SS)

S
shows that the supply of foreign exchange
O Q1 Q2
X
rises from OQ1 to OQ2 when the exchange
Supply for Foreign Exchange
(in Dollars) rate rises from OR1 to OR2.
 Exchange Rate When It Is Not At Equilibrium
Case 1 Y

(Price of Dollar in terms of ₹)

Rate of Foreign Exchange
D Excess Supply S
 The equilibrium exchange rate is determined at a level where the demand for
foreign exchange is equal to the supply of foreign exchange. R2

 In the below diagram, the demand and supply of foreign exchange are R E
measured on the x-axis and the rate of foreign exchange on the y-axis.
R1
 DD is the downward-sloping demand curve of foreign exchange and SS is the
S Excess Demand D
upward-sloping supply curve of foreign exchange. X
O Q2 Q Q1
 Both the curves intersect each other at point “E”. The equilibrium exchange Demand & Supply for Foreign Exchange
(in Dollars)
rate is determined at OR & equilibrium quantity is determined at OQ.

Case 2
 If the exchange rate rises to OR2, then demand foreign exchange will fall to
OQ2 and supply will rise to OQ1. It will be a situation of excess supply. As a
result, the exchange rate will fall till it again reaches the equilibrium level of
OR.
 If the exchange rate falls to OR1, then demand will rise to OQ1 and supply will
fall to OQ2. It will be a case of excess demand. It will push up the exchange rate
till it reaches OR.
 Change in the Exchange Rate
The equilibrium rate will be disturbed if some changes occur in the
demand or supply of foreign exchange.

Change in Demand

Increase in Decrease in
Demand Demand
 An increase in demand leads to a

Increase in Demand : rise in the exchange rate

D S1

 An increase in demand for foreign exchange will shift the D

E1

(Rs. per Dollar)

Exchange Rate
demand towards DD1 to DD2. P2

 It is a situation of excess demand at the original exchange P1 E

rate of OP1. D1

 As a result, the exchange rise to OP2 S

D2

 It shows that the per unit price in US dollars (in terms of Rs) O M M1
Foreign Exchange
has increased. i.e. domestic currency has depreciated. (Dollar)
Equilibrium Exchange Rate

Decrease in Demand :
S

D‟

 A decrease in demand will shift the demand towards the left from
Exchange Rate

R E

E‟
DD to D‟D‟.
R1
 It leads to deficit demand of OQ‟ at the original exchange rate OR.
D
S  As a result, the exchange rate will fall till it reaches OR1.
Q1
D‟
 Now, per unit price of dollars (in terms of Rs) has decreased i.e.
O Q
Demand and Supply of Foreign domestic currency has appreciated.
Currency
 Change in Supply
Y

Increase in Supply : D
S

S‟
 If the supply of foreign exchange increases, it will lead to a E

Exchange Rate
R
rightward shift in the supply curve from SS TO S‟S‟.
 At the original exchange rate of OR, there is an excess supply of R1 E1

QQ1. S
D
 As a result, the new exchange rate moves down to OR1. S‟
X
 It implies that per unit price of US dollars (in terms of Rs) has O Q Q1
Demand and Supply of foreign
reduced i.e. the domestic currency has appreciated. currency

Decrease in Supply :
Y
S‟
D

 A decrease in supply will shift the supply curve towards the left E‟
S

Exchange Rate
R1
from SS TO S'S'.
E
 It leads to a deficit supply of OQ1 at the original exchange rate R

OR. S‟
 This will increase the exchange rate till it reaches OR2. S
D

 The per unit price of the US dollar (in terms of Rs) has increased O Q1 Q
X

Demand and Supply of foreign

i.e., the domestic currency has depreciated. currency
 The foreign exchange market is
the market in which foreign
Meaning currencies are bought and sold.
The buyers and sellers include

of individuals, firms, foreign

exchange brokers, commercial
banks and the central bank.
Foreign The foreign exchange market is a
market, not a place. The
Exchange transactions in this market are
not confined to only one or a few

Market foreign currencies.

This market does not have any
specific location.
Functions of the Foreign Exchange Market
1) Transfer function :
 It transfers purchasing power between the countries involved in the transaction.
 This function is performed through credit instruments like bills of foreign exchange, bank
drafts, and telephonic transfers.

2) Credit function :
 It provides credit for foreign trade. Bills of exchange, with a maturity period of three
months, are generally used for international payments.
 Credit is required for this period to enable the importer to take possession of goods, sell
them and obtain money to pay off the bill.

3) Hedging function :
 When exporters and importers agree to sell and buy goods on some
future date at current prices and exchange rates, it is called hedging.
 The purpose of hedging is to avoid losses that might be caused due to
exchange rate variations in the future.
 Kinds of Foreign Exchange Markets
Spot Market
 Spot market refers to the market in which the receipts and payments are made immediately.
 The spot market is daily and deals only in spot transactions of foreign exchange
(not in future transactions).
 The rate of exchange, which prevails in the spot market, is termed the spot
exchange rate or current rate of exchange.

Forward Market
 Forward market refers to the market in which the sale and purchase of foreign
currency are settled on a specified future date at a rate agreed upon today.
 Forward contract is made for two reasons :
a) To minimize the risk of loss due to adverse changes in the
exchange rate (through hedging).
b) To make profit (through speculation).
 The exchange rate quoted in forward transactions is known as the foreign exchange rate.