Foreign

Exchange
Rate
Chapter 13
 Meaning of Foreign Exchange
Rate

The price at which one currency is exchanged for another is called the rate of exchange. In other words,
the rate of exchange is the price of one currency stated in terms of another currency.
Example:
(i) If one US dollar exchanges for 60 Indian rupees, then the rate of exchange is $1 = 60 rupees or
1rupee = $1/60 or 1.6 cents.

(ii) If one British Pound can be obtained by paying 90 rupees, the exchange rate is 1 British Pound = 90
Indian Rupees (£1 = 90 rupees).

Exchange rate can be expressed in two ways

i) In units of domestic currency: Under it, the number of units of domestic currency for a unit of foreign
currency is expressed
Example : 1 Pound = 90 rupees

ii) In units of foreign currency: Under it, the number of units of a foreign currency for a unit of domestic
currency is expressed:
Example: 1 rupee= 1/90 Pound= 0.11 pound
 Types of Exchange Rate Systems
Exchange rate systems are mainly of 3 types:
i) Fixed Exchange Rate System
ii) Flexible Exchange Rate System
iii) Managed Floating System

Fixed Exchange Rate System

Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed by the
government. Such a rate does not vary with changes in demand and supply of foreign currency. Only
government has the power to change it.

There were 2 systems of fixed exchange rate

i) Gold Standard System
ii) Bretton Woods of Exchange Rate System
 Gold Standard System
Under this system, exchange rate is officially declared and it is fixed. Only a very small change
from this fixed value is possible. A typical fixed exchange rate system was associated with the Gold
Standard Systems of 1880-1914. Under the Gold Standard system, each currency value was
defined in terms of gold and hence, the exchange rate was fixed according to the gold value of
currencies that have to be exchanged. This was referred to as mint part value of exchange.

Example : If one British pound is exchangeable for 125 grains of fine gold and the US dollar ($) for
25 grains, then one pound is equal to 125/25 = 5 US dollars. So the price is fixed at £l = $5. This
was referred to as mint part rate of exchange.

Bretton Woods System

Under Bretton Woods System (named after Bretton Woods-a place in USA where UN nations held a
conference in 1944), gold was replaced by US dollar. Under this system, all currencies were pegged
or linked to US dollar at a fixed exchange rate. Under this system USA guaranteed the convertibility
of dollar into gold at $ 35 per ounce of gold. The Central Bank of each IMF member was committed
to convert its currency into dollar at a fixed price. An adjustment in the parity was possible only
through a direction from the International Monetary Fund.
That is why it was called Adjustable Peg System of Exchange Rate. Gold continued to be the
ultimate unit of parity between any two currencies
 Flexible Exchange Rate System
In a system of flexible exchange rates (also known as floating exchange rates) the exchange rate is
determined freely by the market forces of demand and supply. There is no intervention by the central
banks. Hence, there is no official reserve transactions. A foreign exchange market like other
competitive markets, leads to equilibrium exchange rate at which quantity demanded
equals quantity supplied of foreign exchange.

Demand for Foreign Exchange

The demand for foreign exchange in the foreign exchange market comes from the following:

a) Importers: Importers (firms, households or government) of a country purchase foreign goods

and services. They would then need to pay in foreign currencies. The largest demand for foreign
exchange comes from the importers.

b) Sending Remittances Abroad: Foreign exchange is also demanded for sending remittances (gifts
and other transfer incomes) abroad.

c) Purchase of Financial Assets Abroad: Foreign exchange is also demanded by those who wish to
purchase financial assets (i.e., shares, debentures of a foreign company) abroad.
d) Speculators: Speculators are the persons who buy and sell foreign currencies with the
intention of making profits. They do not buy and sell foreign currency for any economic
consideration such as import or export of goods and services. Their consideration is purely
speculation. For example, if people expect that the price of US dollar in money terms would
increase in future, they will buy dollars today. They will do so in the expectation of making
profits when dollar becomes expensive.

Demand Curve of Foreign Exchange

There is an inverse relationship between price of a Foreign currency (exchange rate) and
demand for Foreign exchange. When exchange rate rises, demand for foreign exchange falls
and vice-versa. That is why demand curve for foreign exchange becomes downward sloping.
 Why there is Inverse Relation between Price and Demand

(a) Reasons for rise in demand for foreign currency when its price falls

The main causes responsible for rise in demand for foreign currency, when its price falls are as
follows
i) Rise in Imports : When price of foreign currency falls, imports from that country become
cheaper. For example, when price of one US dollar falls, say, from 60 to 55 it means less
rupees are required to buy one dollar worth of goods from US. So, imports increase and
hence, demand for foreign currency (dollar in our example) rises.
ii) Promotes Tourism Abroad : When foreign currency becomes cheaper in terms of domestic
currency, it promotes tourism to that (foreign) country. Therefore, demand for that foreign
currency rises.
iii) Increase in Foreign Investment: When price of foreign currency falls, foreign investment
becomes cheaper leading to rise in demand for foreign currency.

(b) Reasons for fall in demand for foreign currency when its price rises

Demand for foreign currency falls, when its price rises. This may be explained in terms of the
following factors.

i) Fall in Imports: When price of foreign exchange rises, imports from that country become
costlier. As a result, imports fall leading to fall in demand for foreign currency.
ii) Discourages Tourism Abroad: When foreign currency becomes costlier in terms of domestic
currency, it discourages tourism to foreign country. This also reduces demands for foreign currency.

iii) Fall in Investment Abroad: When price of foreign currency rises, foreign investment becomes
costlier leading to fall in demand for foreign currency.

Supply of Foreign Exchange

The supply of foreign exchange comes from the following sources:

a) Exporters: Exporters are the major source of supply of foreign exchange. They, when sell goods
and services abroad, would get foreign currencies.

b) Foreign Investment: Foreigners also bring foreign currencies with them, when they wish to
undertake economic activities in another country.

c) Direct Purchases by Non-Residents: The supply of foreign exchange also comes from the non-
residents who make direct purchases in the domestic market.
For example, when a foreigner wants to stay at a hotel in India, he needs to sell foreign currency at
a bank and buy Indian rupees for the payment of hotel bill
 iv) Speculators: Speculators sell foreign currency in the expectation of reducing losses in the
future or gaining presently.

v) Remittances by the Non-Residents Living Abroad.

Supply Curve of Foreign Exchange

There is a direct relation between price of a foreign Currency and the supply of that foreign
currency. The higher the price, the higher is the supply of foreign exchange, and the lower the
price, the lower is the supply. The supply curve, thus, slopes upwards to the right.
 Why there is direct relation between Price and Supply?
(a) Reasons for increase in supply when price of foreign currency rises

Increase in supply of foreign currency due to rise in its price is caused by the following factors

i) Rise in Exports: A rise in foreign exchange rate makes home country's (say, India's) goods
cheaper to foreigners. As a result, foreign demand for goods increases leading to increase in
India's exports. This brings a greater supply of foreign exchange to the domestic country.

i) Attracts foreign tourists : A rise in foreign exchange rate makes home country's currenncy
cheaper which attracts foreigners and promotes tourism to home country (say, India). This
raises supply of foreign exchange.

iii) Increase in Investment by foreigners: Appreciation of foreign currency induce foreigners

to purchase of shares in the domestic economy. Because now purchasing power of the
foreign currency rises in the domestic economy. This leads to increase in supply of foreign
currency.

(b) Reasons for fall in supply when price of foreign currency falls

When price of foreign currency falls, it makes imports, tourism, investment costlier for residents
of that country because they have to pay more now for buying the same amount of goods from
home country (say, India).Therefore, supply of foreign currency falls.
 Managed Floating System
• It is a combination of fixed exchange rate system and flexible exchange rate system.

• The exchange rate is freely determined in the market.

• The central bank intervenes at times to influence the exchange when it is too high or too low.

• Under this system, the central bank attempts to affect the exchange rate directly by buying and
selling of foreign currencies or indirectly through monetary policy (i.e. by lowering or raising interest
rates on foreign currency accounts, affecting foreign investment etc.)

• This system allows adjustments in exchange rate according to set rules and regulations.

• Managed floating in the absence of rules and guidelines could result in excessive intervention. A
particular country could manipulate its managed floating to harm her trading partners. This was
called 'dirty floating’.

• Against this, market determined exchange rate (without any central bank intervention) is called
'clean floating'
 Depreciation and Appreciation
of Domestic Currency
Depreciation of Domestic Currency

Depreciation of domestic currency means fall in the value of domestic currency in terms of foreign currency
in the foreign exchange market. In such a situation, a country has to pay more units of domestic currency to
obtain one unit of foreign currency
Example: Suppose the price of one dollar increases from 62 to 64, it means that earlier we were spending 62
rupees to get one US dollar. But now after rise in its price, we have to pay more, that is, 64 for one dollar. Since we
are spending more rupees for getting the same dollar, the value of rupee in terms of dollar has fallen (i.e.,
depreciated).

Causes of Depreciation

Depreciation of currency occurs due to the following reasons:

1. Increase in demand for foreign currency

2. Decrease in supply of foreign currency
 Difference between depreciation and devaluation

Under the fixed exchange rate system, it is the government who decides when to change the existing
exchange rate. Suppose the government decides to raise the price of foreign currency in terms o bf
domestic currency. This deliberate raising of the price of foreign currency in terms of domestic
currency by the government is termed as devaluation of domestic currency.

Though depreciation and devaluation both imply a fall in the price of a domestic currency in terms of
foreign currency. But the term depreciation is used when a currency loses its value because of changes
in demand and supply of foreign currency. And the term devaluation refers to a reduction in the price
of domestic currency by the government. Thus, depreciation occurs under flexible exchange rate
system while devaluation occurs under fixed exchange rate system.
 Appreciation of Domestic Currency

Appreciation of domestic currency means a rise in the particular price of domestic currency in terms of
foreign currency. The domestic currency becomes more valuable and less units of it are required to buy
one unit of the foreign currency. It is a situation of fall in exchange rate.

Example :Suppose price of one US dollar falls from 64 rupees to 62 rupees. It implies that earlier 64
rupees were required to buy one US dollar. Now one US dollar can be exchanged only for 62. Therefore,
the value of Indian rupee has risen i.e. appreciated in the market.

Causes of Appreciation

i) When demand for foreign currency falls.

ii) When supply of foreign currency rises.
 Difference between Appreciation and revaluation

Appreciation is different from Revaluation. Appreciation means a rise in the price of domestic currency in terms of
a foreign currency. Domestic currency becomes costlier because of changes in demand and supply of a foreign
currency. Revaluation, on the other hand, refers to increase in the price of domestic currency by the government.
It occurs under fixed exchange rate system.

From the above explanation, we sum up the difference between depreciation and appreciation of domestic
currency as under:
 Foreign exchange market

Foreign exchange market refers to the market in which national currencies are traded for one
another. The major participants in this market are commercial banks, foreign exchange brokers
and other authorized dealers and the monetary authorities. According to Lipsey, "The foreign
exchange markets are the markets in which one currency can be traded for another.“

Functions
Foreign exchange market performs the following 3 functions :

1) Transfer Function : It transfers purchasing power between the countries involved in the
transaction.
2) Credit Function : It provides credit in terms of foreign exchange for the export and import of
goods and service across different countries.
3) Hedging Function : It also performs hedging function.It settles exchange rate in advance for
future transactions to cover risk of exchange rate
 Operation of Foreign Exchange

Market Foreign exchange market operates in two ways :

(1)Spot market
(2) Forward market.

(1)Spot Market : In spot market, only spot transactions (or current transactions) are taken up. This
market is of daily nature and does not deal in the future transactions of foreign exchange. The rate
of exchange that prevails in the market at the time of transaction is called spot rate of exchange.

(1)Forward Market : Forward market refers to the market in which sale and purchase of foreign
currency is settled on a specified future date (normally after 90 days) at a rate agreed upon today.
It is commonly seen that most of the international transactions materialize much later than the
value date when the transaction is signed. Since transactions are signed at a point of time and
completed at a later date, forward exchange rate becomes useful for both the parties involved in
transaction. The rate at which forward transactions are contracted is called forward exchange rate.
 Functions of Forward Market

In forward market, three kinds of transactions take place :

(1)Hedging : It settles the exchange rate in advance for future transactions with a view to avoiding the
loss that might arise due to change in exchange rate in future. This function is called 'hedging’.

(2)Arbitraging : It facilitates arbitrage operations i.e., buying and selling of different currencies
simultaneously in two or more exchange markets. The arbitrage operations lead to transfer of
foreign exchange from the markets where exchange rate is low to the markets where exchange rate
is higher. Thus, arbitraging equates the demand for foreign exchange with its supply. It works as a
stabilizing factor with the foreign exchange markets.

(3)Speculation : In a forward market speculators buy a currency when it is weak and sell it when it is
strong and make profit. Also, speculators who expect the spot rate to increase in future, buy
forward at the current rate and sell on the spot' the currency that they have bought. On the
contrary, the speculators who expect a fall in the exchange rate 'sell forward' at the current rate and
buy spot when they need currency for delivery.
 Factors Influencing Exchange Rate

The factors which cause changes in exchange rate are as follows:

(1)Change in Exports and Imports : The demand and supply of foreign exchange is influenced by
changes in exports and imports. If exports of the country are more than imports, the demand for its
currency increases so that the rate of exchange moves in its favour. On the other hand, if imports
are more than exports, the demand for the foreign currency increases and the rate of exchange will
move against the country.

(2)Foreign Investment : Foreign investment refers to purchase of an asset abroad. For example, setting
up of a plant by an MNC, purchases of shares of a company in India. Foreign investment raises the
supply of foreign exchange leading to fall in the price of foreign exchange.

(3)Speculation : Exchange rate in the foreign exchange market also depends on speculative activities.
For example, if Indians think that the US dollar relative to the rupee will appreciate in value in
future, they would like to hold dollars. This expectation of theirs would increase the demand for
dollars right now and cause the rupee dollar exchange rate to the present.

(4)Capital Movements : Short-term or long-term capital movements also influence the exchange rate.
For example, if there is a capital flow from USA for investment in India, the demand for Indian
currency will increase in the foreign exchange market. As a result, the rate of exchange of Indian
rupee in terms of US dollar will rise.