Foreign Exchange
Foreign Exchange
Foreign Exchange
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:
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:
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.
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