MOD 5 c

5.
6 Foreign Exchange Rate:
Foreign exchange rate refers to the rate at which one currency is exchanged for the other in
the market or banks. It represents the price of one currency in terms of another currency.
Types of Foreign Exchange Rate:
i) Fixed exchange rate- It refers to a system in which exchange rate for the government or
central bank of a country fixes a currency for a long period. The basic purpose of adopting this
system is to ensure stability in foreign trade and capital movements. To achieve stability, the
government undertakes to buy foreign currency when the exchange rates becomes weaker and
sell foreign currency when the rate of exchange gets stronger.
ii) Floating exchange rate- It refers to a system in which exchange rate is determined by the
forces of demand and supply of different currencies in the foreign exchange market. The
exchange rate is determined by the market i.e. through the transactions of banks, firms and
other institutions seeks to buy and sell currency for purposes of making transactions in foreign
exchange. The rate changes almost daily.
Determination of exchange rate-
The exchange rate is determined by the demand for (Imports of goods & services, tourism,
unilateral transfers sent abroad, purchase of assets in foreign countries and speculation) and
supply of (exports of goods & services, foreign investments, remittances from abroad and
speculation) of foreign currency.
The foreign exchange market is the market in which the currencies of various countries are
converted into each other or exchanged for each other. It is the demand for and supply of a
foreign currency or exchange that will determine the exchange rate between the two. The
equilibrium exchange rate is determined at a level where demand for foreign exchange is equal
to the supply of foreign exchange.
Both the demand curve (DD) and supply curve(SS) intersect each other at point E. The
equilibrium exchange rate is determined at OR and equilibrium quantity is determined at OQ.
Any exchange rate other than OR is not the equilibrium exchange rate.
If the exchange rate rises to OR1 , then demand for foreign exchange will fall and supply will
rise. It will be a situation of excess supply. As a result, exchange rate will fall till it again
reaches the equilibrium level of OR.
Similarly, if exchange rate falls to OR2, then demand will rise and supply will fall. It will be a
case of excess demand. It will push up the exchange rate till it reaches OR.
Changes in Exchange Rate:

The equilibrium in the foreign exchange market will be disturbed if some changes occur in the
underlying factors that determine the demand for and supply of foreign exchange.
Foreign exchange market:
Foreign exchange market is the market in which foreign currencies are bought and sold. The
buyers and sellers include individuals, firms, foreign exchange brokers, commercial banks and
the central bank.
Kinds of Foreign Exchange Market
1. Spot Market- It refers to the market in which the receipts and payments are made
immediately. The rate of exchange, which prevails in the spot market, is termed as spot
exchange rate or current exchange rate.
2. Forward Market- It refers to the market in which sale and purchase of foreign currency is
settled on a specified date at a rate agreed upon a day. This exchange rate is quoted in forward
transactions is known as the forward exchange rate.
Functions of Foreign Exchange Market
1. Transfer Function- It transfers purchasing power between the countries involved in the
transactions. This function is performed through credit instruments like bills of exchange, bank
drafts and telephonic transfers.
2. Credit Function- It provides credit for foreign trade. Bills of exchange with maturity period
of 3 months are generally used for international payments.
3. Hedging Function- When exporters and importers enter into an agreement to sell and buy
goods on some future date at the current prices and exchange rate, it is called hedging. The
purpose of hedging is to avoid losses that might be caused due to exchange rate variations in
the future.
Currency Appreciation vs. Currency Depreciation:
Currency appreciation refers to increase in the value of domestic currency in terms of foreign
currency. The domestic currency becomes more valuable and less of it is required to buy
foreign currency.
Example- Indian currency appreciates when price of $1 falls from ₹60 to ₹50.
It leads to increase in imports from U.S. as American goods will become relatively cheaper.
Currency depreciation on the other hand, refers to decrease in the value of domestic currency
in terms of foreign currency. It makes the domestic currency less valuable and more of it is
required to buy foreign currency.
Example- Indian rupee depreciates when price of $1 rises from ₹45 to ₹50.
It means with the same amount of dollars, more goods can be purchased from India i.e. exports
to U.S will increase, as they will become relatively cheaper.
Difference between Devaluation and Depreciation:
Devaluation refers to reduction in price of domestic currency in terms of all foreign currencies
under fixed exchange rate regime. It takes place due to government.
Depreciation on the other hand, refers to fall in market price of domestic currency in terms of
a foreign currency under flexible exchange rate regime. It take place due to market forces of
demand and supply.
Difference between FERA and FEMA
Foreign Exchange Management Act, 1999(FEMA) emerged as a replacement or say an

improvement over the old Foreign Exchange Regulation Act, 1973( FERA).
Basis of Comparison FERA FEMA
1. Meaning An Act promulgated An act initiated to facilitate
to regulate payments, external trade and payments
in foreign exchange and and to promote orderly mngt.
securities in India of forex market in the country.
2. Enactment Old New
3. No. Sections 81 49
4. Introduced when Foreign exchange Foreign exchange position
reserves were low was satisfactory
5. Approach towards Rigid Flexible
forex transactions
6. Basis for determining Citizenship More than 6 months stay in India
residential status
7. Violation Criminal Offence Civil Offence
8. Punishment Imprisonment Fine or Imprisonment
for Contravention

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5.

6 Foreign Exchange Rate:

Types of Foreign Exchange Rate:

Determination of exchange rate-

Changes in Exchange Rate:

Kinds of Foreign Exchange Market

Functions of Foreign Exchange Market

Currency Appreciation vs. Currency Depreciation:

Difference between Devaluation and Depreciation:

Foreign Exchange Management Act, 1999(FEMA) emerged as a replacement or say an

Basis of Comparison FERA FEMA

1. Meaning An Act promulgated An act initiated to facilitate

to regulate payments, external trade and payments

in foreign exchange and and to promote orderly mngt.

securities in India of forex market in the country.

2. Enactment Old New

4. Introduced when Foreign exchange Foreign exchange position

reserves were low was satisfactory

5. Approach towards Rigid Flexible

6. Basis for determining Citizenship More than 6 months stay in India

7. Violation Criminal Offence Civil Offence

8. Punishment Imprisonment Fine or Imprisonment

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