Foreign Exchange

Download as pdf or txt
Download as pdf or txt
You are on page 1of 7

PRAGATI PUBLIC SCHOOL (2024-2025)

CLASS: XII
SUBJECT: ECONOMICS (030)
TOPIC: FOREIGN EXCHANGE RATE
NOTES
Foreign Exchange(Forex): refers to any currency other than the domestic currency.
Eg: India’s domestic currency is dollar and all other currencies like US Dollar, British Pound are
foreign exchange.
Foreign Exchange rate: It is the rate at which one currency is exchanged for the other.
OR
The price of one currency in terms of another currency is known as the foreign exchange rate.
Eg: 1 US dollar= 70
Foreign Exchange market: is the market where foreign currency is bought and sold like
commercial banks, foreign exchange brokers and other authorised dealers etc.
Types of Exchange Rate:
1. Fixed Exchange Rate System (or pegged exchange rate system)
2. Flexible Exchange Rate System (or Floating exchange rate system)
3.Managed Floating Exchange Rate System
1.Fixed Exchange Rate System: Definition: is the rate in which exchange rate is fixed by the
central government . The government is responsible to stabilize the exchange rate. In this
system, each country maintain value of its currency fixed in terms of gold, silver or another
country’s currency etc.

Graphical Explanation : In the diagram(fig6.3) below, the market determined exchange rate is
e.
Let us suppose that for some reason the Indian Government wants to encourage exports for
which it needs to make rupee cheaper for foreigners it would do so by fixing a higher exchange
rate e1. At this exchange rate, the supply of dollars exceeds the demand for dollars.
The RBI intervenes to purchase the dollars for rupees in the foreign exchange market in order
to absorb this excess supply which has been marked as AB in the figure.
On the other hand, if the government was to set an exchange rate at a level such as e2, there
would be an excess demand for dollars in the foreign exchange market.
To meet this excess demand for dollars, the government would have to withdraw dollars
from its past holdings of dollars. Thus, through intervention, the Government maintain exchange
rate in the economy
Variants of Fixed Exchange Rate System
Gold Standard System of Foreign Exchange: According to Gold Standard, external values of all
currencies were maintained by fixing their prices in terms of gold. Central bank of each country
was ready to buy and sell unlimited quantities of gold at a fixed price in terms of its own
currency. For example, if £1 = 4 gm of gold and $1 = 2 gm of gold, then exchange rate will be £1
= $2
Bretton Woods System of Foreign Exchange Rate: According to Bretton Woods Standard, gold
was replaced by US dollar as the 'core' of the system. Under this system, all currencies were
pegged or related to US dollar at a fixed exchange rate.
Merits of Fixed Exchange rate system: Ensures stability and prevents speculation.
Demerits: 1. Possibility of under or over valuation of currency2. Government must maintain
gold reserves
Devaluation and Revaluation
Devaluation: refers to fall in the value of domestic currency with respect to foreign currency
due to government action under fixed exchange rate system. This makes domestic goods
cheaper.
Effect of Devaluation:

 Devaluation leads to increase in exports and decrease in imports


 Increase in National Income as net exports increases
 Balance of Trade (Trade Balance) will be in surplus
 Official reserves of RBI increases
Revaluation: refers to rise in the value of domestic currency with respect to foreign currency
due to government action under fixed exchange rate system. This makes domestic goods
costlier.
Effect of Revaluation :
 It leads to increase in imports and decrease in exports.
 Decrease in National Income as net exports decreases
 Balance of Trade will be in deficit (thereby increasing foreign dependency)
 Official reserves of RBI reduces
2. Flexible Exchange Rate system:
Meaning: This exchange rate is determined by the market forces of demand and supply. It is
also known as Floating Exchange Rate.
Demand for Foreign Exchange:
Sources of Demand of Foreign Exchange:

 Import of goods and services


 Tourism abroad (Visiting abroad)
 For making Investments abroad (Purchase of assets in foreign countries(
 Repayment of International loans
 Unilateral transfers (Send gifts abroad)
 Foreign Exchange speculation: Foreign currency is demanded if its value is going to
appreciate in future. So speculators buy foreign currency when its price is low and sold
it when its price is high.
Demand curve of foreign Exchange
Demand curve(DD) of foreign exchange is downward sloping as there is an inverse
relationship between foreign exchange rate and demand of foreign exchange as shown in the
diagram below:

This means that a rise in price of foreign exchange will increase the cost (in terms of rupees) of
purchasing a foreign good. This reduces demand for imports and hence demand for foreign
exchange also decreases, other things remaining constant and vice versa for fall in price of
foreign exchange.
Supply of Foreign Exchange: Sources of Supply of Foreign Exchange:

 Exports of goods and services


 Investments from rest of the world
 Foreign tourism
 Loans and grants from rest of the word
 Unilateral transfers from abroad by Normal residents
 Speculation
Supply curve of foreign exchange is downward sloping:
There is a positive relationship between foreign exchange rate and supply of foreign
exchange Hence Supply curve(SS) is upward sloping as shown in the diagram below.

This means that a rise in price of foreign exchange will reduce the foreigner’s cost (in terms of
USD) while purchasing products from India, other things remaining constant. This increases
India’s exports and hence supply for foreign exchange may increase vice versa for fall in price of
foreign exchange.
Determination of Foreign Exchange Rate under Flexible Exchange Rate system
Graphically, the exchange rate is determined
where the demand curve(DD) of foreign currency
intersects with the supply curve(SS)
of foreign currency, i.e.,
at point R on the Y – axis.
Point Q on the x – axis determines the quantity of US Dollars
that have been demanded and supplied on R exchange rate
Any Exchange rate other than R will not be equilibrium exchange rate. If the rate of exchange is
not in equilibrium, then there is situation of either excess demand or excess supply as shown in
the diagram. In such a situation, free play of forces such as supply and demand work in such a
manner that the equilibrium rate of exchange is automatically restored.
Merits: a) It solves the problem of overvaluation or undervaluation of currencies.
b) There is no requirement of government to hold large foreign exchange reserves.
d) There is optimum utilization of resources
Demerits: a) There is no stability. Flexible exchange rate keeps fluctuating according to demand
and supply. b) This discourages international trade and coordination of macro policies becomes
inconvenient.

Changes in the Exchange rate


The equilibrium will be disturbed due to changes in demand or supply of foreign currency
a. Change in demand
1. Increase in Demand: Causes demand curve to shift
rightwards from DD to D1D1 as shown in the diagram
There will be excess demand at the original exchange rate
as a result exchange rate rises to R1. Hence domestic
currency depreciated
Effect of Increase in Demand:
 Rise in Exchange rate
 Depreciation of domestic currency
 Increase in exports (as domestic goods cheaper)
and decrease in imports
 Increase in National Income

2. Decrease in Demand: Causes demand curve to shift


leftwards from DD to D2D2 as shown in the diagram
There will be deficit demand at the original exchange rate
as a result exchange rate falls to R2 .
Hence domestic currency appreciated
Effect of decrease in demand
 Fall in Exchange rate
 Appreciation of domestic currency
 Decrease in exports
Decrease in National Income

b. Change in supply
1.Increase in Supply : Causes supply curve to shift
rightwards from SS to S1S1
There will be excess supply at the original exchange
rate as a result exchange rate falls to R as a result
exchange rate falls to R2.
Hence domestic currency appreciated
Effect of increase in supply
 Fall in Exchange rate
 Appreciation of domestic currency
 Decrease in exports (as domestic goods costlier)
and imports increases
Decrease in National Income

2. Decrease in Supply: Causes supply curve to shift leftwards from SS to S2S2 as shown in the diagram
above There will be deficit supply at the original exchange rate as a result exchange rate rises to R2
Hence domestic currency depreciate
Effect of decrease in supply
 Rise in Exchange rate
 Depreciation of domestic currency
 Increase in exports and decrease in imports
 Increase in National Income

Appreciation and Depreciation of Currency


Depreciation is fall in the value of domestic currency in terms of foreign currency by the
market forces of demand and supply under flexible exchange rate system. For example one
dollar is exchanged for ruppes 70 and now the exchange rate falls to rupees 60 per dollar.
This is depreciation of domestic currency and it makes domestic goods cheaper
Effect of Depreciation:

 Depreciation leads to increase in exports and decrease in imports


 Increase in National Income as as net exports increases
 Balance of Trade (Trade Balance) will be in surplus
Official reserves of RBI increases
Appreciation is rise in the value of domestic currency in terms of foreign currency by the
market forces of demand and supply under flexible exchange rate system. For example, one
dollar is exchanged for rupees 70 and now the exchange rate increases to rupees 75 per
dollar. This is appreciation of domestic currency and it makes domestic goods costlier.
Effect of Appreciation

 It leads to increase in imports and decrease in exports.


 Decreases in National Income as net exports decreases
 Balance of Trade will be in deficit (thereby increasing foreign dependency)
 Official reserves reduce
3. Managed floating exchange rates
In a system of managed floating exchange rates, the exchange rate is determined by the
combined forces of demand and supply of foreign exchange, but the central bank may
intervene to buy or sell foreign currencies in order to control the exchange rate fluctuations.
It is also known as dirty floating.
Note: Official reserve transactions are, therefore, not equal to zero.

You might also like