Topic: Foreign Exchange Rate Determination – Methods &

Techniques

1) Introduction
Foreign exchange rates are crucial for the global economy because they
determine how much one country’s money is worth compared to another’s.
These rates affect everything from the price of imported goods to the cost of
travel abroad and the value of investments in different countries. They play a
key role in how countries trade with each other, how they manage their
economic policies, and how competitive their businesses are internationally.

The purpose of this project is to understand how foreign exchange rates are
set and what factors influence their movements. This means looking into
various methods and techniques used to figure out the value of a country’s
currency compared to others, and understanding the economic and financial
factors that cause exchange rates to rise or fall.

2) Details
➢ Foreign Exchange Rate – Definition
A foreign exchange rate indicates the value of one currency compared to
another and determines the rate at which currencies can be exchanged. It
represents the price one currency must be paid in to acquire another currency.
These rates are essential for conducting international trade and investment
transactions, as they establish the cost of buying goods and services from other
countries and influence the returns on foreign investments. Additionally,
exchange rates are closely monitored by governments and central banks as they
play a significant role in shaping economic policies and managing
macroeconomic stability.

➢ Different Foreign Exchange Rate Systems:

I. Fixed Exchange Rate System:
Gold Standard Exchange Rate:
The gold standard, a historic exchange rate mechanism, linked the value of a
country's currency directly to a specific quantity of gold. Governments
maintained fixed exchange rates between their currency and gold, ensuring that
the currency could be exchanged for a set amount of gold. This system provided
stability to the international monetary system during the 19th and early 20th
centuries, fostering confidence in currencies and facilitating international trade
and investment. However, its rigidity became a drawback, as countries faced
challenges in adjusting their monetary policies to address economic
fluctuations. Despite its stability, the gold standard lacked flexibility,
constraining policymakers' ability to respond effectively to changing economic
conditions. Consequently, most countries abandoned the gold standard during
the Great Depression, opting for more flexible exchange rate regimes to better
accommodate the complexities of modern economies.

Bretton Woods Exchange Rate System:

The Bretton Woods exchange rate system, established in 1944, introduced a
new international monetary order following World War II. Under this system,
participating countries agreed to fix their exchange rates relative to the US
dollar, which was convertible to gold at a fixed rate of $35 per ounce. This
arrangement aimed to provide stability to the global economy by anchoring
currencies to a reliable benchmark and facilitating international trade and
investment. However, the system faced inherent challenges, including persistent
trade imbalances and pressure on the US dollar's convertibility to gold due to
inflationary pressures in the United States. These imbalances eventually led to
the collapse of the Bretton Woods system in 1971 when US President Richard
Nixon suspended the dollar's convertibility to gold, effectively ending the fixed
exchange rate regime. Despite its stability, the Bretton Woods system was
unable to withstand the economic realities of the post-war era, highlighting the
inherent limitations of fixed exchange rate systems in managing global
economic dynamics.

II. Flexible Exchange Rate System:

• Determination of foreign exchange rate on basis of demand &
supply:
a) Demand for Foreign exchange
The demand for foreign exchange is intricately linked to the relationship
between foreign exchange rates and the quantity demanded. When the price
of foreign currency falls relative to the domestic currency, it stimulates
demand for imports and tourism, as they become more affordable.
Additionally, speculation and the need to repay international loans in foreign
currency further contribute to demand. These dynamics illustrate the inverse
relationship between exchange rates and the quantity of foreign currency
demanded, forming the basis for the demand curve in the foreign exchange
market.

Various sources contribute to the demand for foreign exchange. Import

payments, tourism expenditures, unilateral transfers, asset purchases in
foreign countries, speculation, and loan repayments all require foreign
currency. These diverse demands collectively shape the demand curve,
reflecting the quantity of foreign currency demanded at different exchange
rates. As exchange rates fluctuate, the demand curve responds accordingly,
illustrating the fundamental principle of the inverse relationship between
exchange rates and the quantity of foreign currency demanded.

a) demand curve b) supply curve

b) Supply of Foreign exchange

The supply of foreign exchange, essential for a country's international trade
and financial transactions, is influenced by various factors. These include
exports of goods and services, foreign investment, remittances from abroad,
speculative activities, and financial inflows such as loans and grants. When a
country exports goods and services, it receives payments in foreign currency,
increasing the supply of foreign exchange. Similarly, foreign investment,
remittances, and financial transactions from the rest of the world contribute to
this supply. Additionally, speculation on future exchange rate movements can
also impact the supply of foreign exchange, as speculators seek to profit from
anticipated currency fluctuations.

The relationship between the foreign exchange rate and the supply of foreign
exchange is typically positive, resulting in an upward-sloping supply curve. As
the exchange rate of a country's currency increases, the supply of foreign
exchange tends to rise. This is because a higher exchange rate makes domestic
goods relatively cheaper for foreign buyers, stimulating exports and increasing
the inflow of foreign currency. Moreover, a stronger domestic currency can
attract more foreign investment, encourage remittances and transfers from
abroad, and incentivize speculative activity. These dynamics contribute to the
responsiveness of the supply of foreign exchange to changes in the exchange
rate, shaping the upward slope of the supply curve.
c) Determination of equilibrium foreign exchange rate
The equilibrium foreign exchange rate is determined by the convergence of
demand and supply in the foreign exchange market. Represented graphically,
this equilibrium is achieved at the point where the downward-sloping demand
curve intersects with the upward-sloping supply curve. At this juncture, the
quantity of foreign exchange demanded equals the quantity supplied,
establishing market equilibrium. Any deviation from this equilibrium prompts
market forces to act, adjusting the exchange rate until balance is restored.

d) Changes in exchange rate:

• Change in Demand:
Changes in exchange rates, leading to appreciation or depreciation of the
domestic currency, occur due to shifts in the demand curve for foreign
exchange. Appreciation happens when demand for the domestic currency rises
relative to foreign currencies, driven by factors such as improved economic
performance or higher interest rates. Depreciation occurs when demand for
the domestic currency falls compared to foreign currencies, often due to
economic downturns or lower interest rates. These shifts in demand directly
influence exchange rate movements, impacting the relative value of currencies
in international markets.

• Change in Supply:
Changes in exchange rates stem from shifts in the supply curve of foreign
exchange. An increase in currency supply typically triggers depreciation,
signaling surplus, while a decrease leads to appreciation, indicating scarcity.
Factors like interest rates, economic stability, and government policies
influence currency supply, impacting exchange rates. For example, a central
bank's decision to boost money supply can depreciate the domestic currency
by flooding the market, reducing its value against other currencies.

➢ DEPRECITION OF CURRENCY vs DEVALUATION OF CURRENCY:

III. Hybrid Systems:

a) Crawling Peg System:

The crawling peg system maintains a fixed exchange rate but adjusts it
periodically, offering both stability and flexibility. This approach allows for
gradual adjustments in response to economic changes, providing stability while
ensuring competitiveness. Examples include Chile and China, where this
system effectively managed exchange rate fluctuations while supporting
economic growth.

b) Managed Floating System:

In a managed floating exchange rate system, market forces primarily dictate
currency values, but governments occasionally intervene to curb excessive
volatility or maintain economic stability. This hybrid model offers the flexibility
of floating rates while providing some stability through intervention when
needed. Examples include the approaches taken by countries like Canada and
Australia, where central banks intervene to manage currency fluctuations while
allowing market dynamics to influence exchange rates.

➢ FOREIGN EXCHANGE MARKET

The foreign exchange market (Forex) plays pivotal roles in the global economy.
Firstly, it facilitates currency conversion, essential for international trade and
investment. Secondly, it enables hedging against exchange rate fluctuations,
crucial for managing risk. Thirdly, it provides avenues for speculation, allowing
traders to profit from currency value changes. Finally, it offers opportunities for
arbitrage, exploiting variations in exchange rates across markets. These
functions collectively support global trade, risk management, and profit
generation in currency trading.

➢ KINDS OF FOREIGN EXCHANGE MARKETS

a) Spot Market:
In the spot market, currencies are traded for immediate delivery, typically
within two business days. It operates continuously across major financial
centers, offering high liquidity, tight spreads, and low transaction costs. Prices
are determined by supply and demand dynamics, reflecting current market
conditions. This market serves as the backbone of international trade,
investment, and speculation, meeting instant currency conversion needs
efficiently.

b) Forward Market:
1. The forward market facilitates contracts for future currency exchanges,
allowing parties to lock in exchange rates for specified future dates.
These contracts, known as forward contracts, are customized to manage
currency risk effectively. By securing rates today for transactions in the
future, forward contracts provide stability and predictability amidst
currency fluctuations. They operate over-the-counter, offering flexibility
and tailored solutions negotiated directly between parties.

3) Causes:
➢ Reasons for Phasing Out of Fixed Exchange Rate System:

Economic Rigidity: Fixed exchange rates lacked the flexibility needed to

respond effectively to economic shocks. Without the ability to adjust
currency values, countries struggled to adapt to changing economic
conditions, leading to instability and inefficiency.
2. Imbalances: The fixed exchange rate system exacerbated trade
imbalances by constraining adjustments in currency values. Persistent
trade deficits or surpluses were difficult to address within this
framework, resulting in unsustainable economic conditions and tensions
between trading partners.
3. Gold Reserves: The fixed exchange rate system relied on gold reserves
to support global liquidity needs. However, these reserves were
inadequate to meet the growing demands of international trade and
 finance, leading to strains on the system and contributing to its eventual
collapse.
4. Speculation: Fixed exchange rates were highly vulnerable to speculative
attacks, where traders exploited perceived discrepancies between the
fixed rate and market fundamentals. These attacks could trigger rapid
currency devaluations or destabilize financial markets, undermining
confidence in the system and necessitating its reform or abandonment.

These factors collectively undermined the viability and effectiveness of the

fixed exchange rate system, ultimately leading to its phased-out transition in
favor of more flexible exchange rate arrangements.

➢ Why Was Flexible Exchange Rate Adopted?

1. Economic Flexibility: Flexible exchange rates enable countries to adapt
to changing economic conditions by allowing their currency values to
fluctuate. This adjustment helps in scenarios like recessions or
overheating economies, where currency depreciation or appreciation
can stimulate exports or curb inflation, respectively.
2. Market Efficiency: Flexible exchange rates reflect the true economic
value of a currency more accurately than fixed rates. Market forces of
supply and demand determine exchange rates, ensuring alignment with
economic fundamentals like interest rates, inflation, and trade balances.
This fosters greater market efficiency as participants can make informed
decisions based on exchange rate information.
3. Independent Policies: Flexible exchange rates grant countries the
autonomy to pursue independent monetary policies suited to their
domestic economic needs. Unlike fixed exchange rate systems that
restrict policy options to maintain a pegged rate, flexibility allows central
banks to adjust interest rates and other tools according to domestic
conditions, enabling more effective responses to economic challenges.

4) EFFECTS:

Merits of Fixed Exchange Rate System:

1. Stability - Predictable exchange rates: Fixed exchange rates offer
stability by providing businesses and investors with predictable
exchange rates, fostering a conducive environment for trade and
investment planning.
 2. Control - Reduces risk of currency crises: By fixing exchange rates,
countries can mitigate the risk of currency crises, as fluctuations are
limited, and there's less uncertainty in the foreign exchange market.
3. International Confidence - Enhances trust in currency value: Fixed
exchange rates can enhance international confidence in a currency's
value, as it signifies a commitment from the government or central bank
to maintain a stable exchange rate, which can attract foreign
investment.

Demerits of Fixed Exchange Rate System:

1. Lack of Flexibility - Difficulty in adjusting to economic changes: Fixed
exchange rates lack the flexibility to adjust to changing economic
conditions, which can lead to imbalances and hinder economic growth.
2. Economic Strain - Pressure on gold reserves or anchor currency:
Maintaining fixed exchange rates may exert pressure on a country's gold
reserves or the anchor currency it's pegged to, especially if there's
sustained speculation against the fixed rate.
3. Speculative Risk - Potential for forced devaluation: Speculators may
target currencies in a fixed exchange rate system, leading to speculative
attacks that could force a country to devalue its currency, resulting in
economic instability.

Merits of Flexible Exchange Rate System:

1. Automatic Adjustment - Currency value reflects economic conditions:
Flexible exchange rates allow currencies to adjust automatically based
on market forces, ensuring that currency values align with economic
fundamentals.
2. Policy Independence - Freedom in domestic economic policies:
Countries with flexible exchange rates have the autonomy to pursue
domestic economic policies without being constrained by the need to
maintain a fixed exchange rate.
3. Crisis Absorption - Better absorbs external economic shocks: Flexible
exchange rates can absorb external economic shocks more effectively by
allowing currencies to depreciate or appreciate in response to changing
economic conditions, thus aiding in crisis management.

Demerits of Flexible Exchange Rate System:

 1. Volatility - Unpredictable exchange rate fluctuations: Flexible exchange
rates can be volatile, leading to uncertainty for businesses and investors
and potentially disrupting trade and investment flows.
2. Speculation - Increased risk of speculative attacks: Flexible exchange
rate systems are susceptible to speculative attacks, as currency values
are determined by market forces, which can lead to destabilizing
fluctuations.
3. Inflation - Potential for inflationary pressures: Depreciation of a
currency in a flexible exchange rate system may lead to imported
inflation, as the cost of imported goods rises, potentially putting upward
pressure on domestic prices.

5) Data Analysis:

6) CONCLUSION
Throughout this project, I've learned a lot about how foreign exchange rates
affect countries' economies. It's like a big puzzle where every piece, or
currency, affects the others. Keeping a close eye on these rates is super
important for countries to keep their finances in check. If they don't, things can
get pretty messy.

Watching exchange rates helps countries figure out if they're doing well or not
in terms of trade and money flowing in and out. For example, when a country's
currency gets stronger, it's harder for them to sell stuff abroad because it
becomes more expensive for other countries. That can lead to less money
coming in and more going out, which isn't great for their economy.

On the flip side, when a country's currency gets weaker, it can help their
exports because things become cheaper for other countries to buy. But if it
stays weak for too long, it can cause some big problems. Take India, for
instance. When the Indian rupee loses value, it makes it harder to attract
foreign investors because they worry about the economy being unstable. This
can slow down economic growth and job opportunities.

Plus, a weaker rupee means stuff from other countries becomes more
expensive for Indians to buy, especially things like oil. Since India depends a lot
on imported oil, this can really hurt its economy and push up prices for
everyone.
So, understanding how exchange rates work is super important for countries to
make smart decisions about their economy. It's like knowing which way the
wind is blowing before setting sail. If you're not careful, you might end up in
rough waters.

7) BIBLIOGRAPHY:
Economic Times, Financial Express, Business Standard, The Hindu (2020-2023).
Various articles on the Indian rupee and foreign exchange markets.

https://byjus.com/commerce/foreign-exchange-rate

https://www.geeksforgeeks.org/determination-of-exchange-rate/

https://www.geeksforgeeks.org/foreign-exchange-rate-meaning-and-types/?
ref=lbp

https://www.geeksforgeeks.org/currency-depreciation-and-currency-
appreciation/?ref=lbp

https://www.geeksforgeeks.org/types-of-foreign-exchange-rate/?ref=lbp