DETERMINATION OF FOREIGN EXCHANGE RATE

FOREIGN EXCHANGE RATE​: It is the rate at which currency of one country can be
exchanged for currency of another country.
For eg: If 1$ can be exchanged for Rs 70 then value of Re 1 is (1/70) $= 0.014 $

FOREIGN EXCHANGE​: All currencies other than the domestic currency of a country
are foreign exchange. For eg: US dollar, British Pound etc.

FOREIGN EXCHANGE MARKET​: It is the market in which national currencies of

various countries are converted, exchanged or traded for one another. It is not a
physical place but includes Banks, specialised foreign exchange dealers, brokers,
official govt agencies etc.

FUNCTIONS OF FOREIGN EXCHANGE MARKET

1. Transfer function​: It transfers the purchasing power between the countries. It is
performed through credit instruments like bills of foreign exchange, bank drafts,
telephonic transfers etc.
2. Credit Function​: It provides credit for foreign trade to enable the importer to
take possession of goods, sell them and obtain money to pay off the bill. ( Bill of
exchange with maturity period of 3 months is 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. Its purpose is to avoid losses that might be caused due to
exchange rate variations in the future.

SOURCES OF DEMAND FOR FOREIGN EXCHANGE

Foreign Exchange is demanded by domestic residents for the following reasons:
1. To purchase goods and services from foreign countries ​or imports
2. To undertake foreign tours.
3. For making transfer payments like sending gifts abroad, donations, cash
remittances to families etc.
4. To purchase assets like land, factories, shares, bonds etc.
5. To speculate on the value of foreign currencies.
SHAPE OF THE DEMAND CURVE FOR FOREIGN EXCHANGE

● There is an inverse relation between price of foreign exchange and the demand
for foreign exchange in terms of domestic currency.
● It is a downward sloping curve.
● Suppose the present price of US $ is Rs 70 and let it fall to Rs 60. This means that
now India has to part with Rs 60 to buy 1 US$ worth of goods. It also implies that
American goods have now become cheaper. At a lower price of US $ India is
likely to buy more goods from the USA. This raises demand for US $. Thus lower
the price of US $, higher is the demand for US $.
1$=70Rs ( 70 Rs = 100 candies)
1$=60 Rs
● Its impact is imports , education and travel becomes cheaper.

SOURCES FOR SUPPLY OF FOREIGN EXCHANGE

Domestic Currency is supplied to foreigners for the following reasons:
1. When foreigners purchase goods and services from India through exports
2. When foreign tourists visit India.
3. From transfer payments like gifts, donations, cash remittances to families in
India.
4. When foreigners invest in bonds, shares and properties of India.(​making
investment abroad)
5. To speculate on the value of domestic currencies.
SHAPE OF THE SUPPLY CURVE FOR FOREIGN EXCHANGE
● There is a direct relation between price of foreign exchange and supply of foreign
exchange.
● It is an upward sloping curve.

● Suppose the price of US $ in India falls from Rs 70 to Rs 60. This means now
USA can buy Rs 60 worth of goods from India by parting with 1 US $. Indian
goods become costlier for USA and it buys less of Indian goods. This reduces the
supply of US $ to India. Thus lower is the price of US $, lower is its supply. Thus,
its impact is that exports become expensive.
1$= 70 Rs.
1$=60Rs.

● Similarly when the price of US$ in India rises from Rs 60 to Rs 70, this means
now USA can buy Rs 70 worth of goods from India by parting with 1 US$.
Indian goods become cheaper for USA and it buys more of Indian goods. This
increases the supply of US $ to India. Thus higher is the price of US $, higher is
its supply.
DETERMINATION OF FOREIGN EXCHANGE RATE
● The equilibrium rate of foreign exchange is determined by the intersection of
forces of demand and supply of foreign exchange.
● The equilibrium rate is the rate at which the quantity demanded of a foreign
currency equals the quantity supplied of that currency.

● In the diagram OP is the market exchange rate & OQ is the equilibrium

quantity.
● In case the rate is below the equilibrium level, say E1, there would be excess
demand which would push the rate up till it reaches the equilibrium E.
● In case the rate is above the equilibrium level, say E2, there would be excess
supply which would push the rate down till it reaches the equilibrium E and
there is no tendency to change.
CURRENCY APPRECIATION
● It refers to an increase in the value of domestic currency in terms of foreign
currency.
● It indicates domestic currency is more valuable and less of it is required to buy
foreign currency.
● For eg: 1$= 60 Rs which becomes 55 Rs. It means Appreciation of Indian Re.

Effects
a) It makes foreign goods cheaper as more of such goods can be purchased with the
same amount of domestic currency. Hence, it leads to an increase in imports from
USA as American goods become relatively cheaper.
b) Education and travel abroad becomes cheaper.
c) Exports become expensive.
d) Value of remittances will become less as those who are earning in dollars will get
lesser in Rs.
Change in Exchange rate
Diagrams: ​ SG 11.9 2 diagrams of fall in foreign exchange.
1) Increase in supply of foreign exchange leads to a rightward shift in supply curve
from SS1 to SS2. New exchange rate moves down to OP2.

2) Decrease in demand shifts demand curve towards left from D to D1 and

exchange rate falls to e2

Eg: $3= Pound1

$5= Pound 1 This implies that pound appreciates and $ depreciates
CURRENCY DEPRECIATION
● It refers to the decrease in the value of domestic currency in terms of foreign
currency.
● It indicates domestic currency is less valuable and more of it is required to buy
foreign currency.
● For eg: 1$= 60Rs which becomes 70Rs i.e. depreciation of India rupee.

Effects
a) It makes domestic goods cheaper in foreign country as more of such goods can
now be purchased with the same amount of currency. It leads to an increase in
exports to USA as Indian goods become relatively cheaper.
b) Education and travel abroad becomes expensive.
c) Imports become expensive and hence fall.
d) Value of remittances will increase as those who are earning in dollars will get
more in Rs.

Change in Exchange Rate

Diagrams: ​ SG 11.9 2 diagrams of rise in foreign exchange.
1) Increase in demand for foreign exchange shifts demand curve towards right
from DD1 to DD2 and exchange rate rises to OP2.

2) Decrease in supply of exchange shifts supply curve to left from S2 to S1 and

exchange rate rises to OP

Eg: $3 =Pound 1
$2 = Pound 2
This implies that UK Pound depreciates
 DEVALUATION DEPRECIATION
It refers to the decrease in the value of It refers to the decrease in the value of
domestic currency in terms of foreign domestic currency in terms of foreign
currency under fixed exchange rate currency under flexible exchange rate
regime, i.e. when exchange rate is not regime i.e. when exchange rate is
determined by the forces of demand determined by the market forces of
and supply but is fixed by the govt of demand and supply in the
different countries. international money market.
It is always announced by the It takes place due to market forces of
monetary authority of the govt. demand and supply of foreign
exchange.

FIXED EXCHANGE RATE FLEXIBLE EXCHANGE RATE

SYSTEM SYSTEM
It is officially fixed in terms of gold or It is determined by market forces of
any other currency by the demand and supply of foreign
government. exchange in the foreign exchange
market.
There is complete government There is no government intervention.
control over it.

It ensures stability in exchange rate Fluctuations in foreign exchange rate

which promotes foreign trade as hampers foreign trade and capital
there is certainty about future movement between countries bcoz of
exchange rate. uncertainty in future exchange rate.
It prevents speculation in foreign It encourages speculation in foreign
exchange market. exchange market.
There is no automatic adjustment of It leads to automatic adjustment of
BOP. Balance of Payments.

This system has less chances of If the exchange rate continues to rise,
inflation on account of rising it may lead to inflation in the
exchange rate. economy.
It increases dependence on external It makes the govt independent of
sources. foreign pressures.
The govt has to maintain a reserve of There is no need for the govt to hold
foreign exchange which has to be any reserves of foreign exchange as
released in the market whenever the market automatically takes care.
there is shortage.
MANAGED FLOATING RATE SYSTEM
It refers to a system in which foreign exchange rate is determined by market forces and
Central Bank is a key participant to stabilize the value of currency in case of extreme
appreciation or depreciation.

Features
1. It is a hybrid of fixed and flexible exchange rates.
2. Refer to diagram of excess supply and excess demand . ​When the central bank
finds the floating rate too high, RBI increases the demand for rupees by
exchanging dollars for Rs. It starts selling foreign exchange from its reserve to
bring down the rate. ( i.e. supply of forex increase)
3. When the central bank finds the floating rate too low, RBI increases the supply
of rupees by exchanging dollars for Rs. It starts buying to raise the rate. (i.e.
demand of forex increase)
4. For this the Central Bank maintains reserves of foreign exchange to ensure that
the rate remains within the targeted value.
5. The central bank does it in the interest of importers and exporters.
6. Managed Floating rate is also called ​dirty floating rate ​ when a particular
country manipulates its managed floating rate to the detriment of other
countries.

SPOT MARKET: ​ A market which covers sale and exchange of foreign exchange of
daily nature. Also called the current market.

FORWARD MARKET:​ A market in which foreign exchange is bought and sold for
future delivery. It covers transactions which occur at a future date for 2 reasons:
a) To minimise risk of loss due to adverse change in exchange rates (hedging)
b) To make profits (speculation)

( For reference:
2. For lowering exchange rate:
a) Increase supply of foreign exchange => fall in supply of rupee
b) Decrease in demand of foreign exchange => Increase in demand of rupees
Govt will follow a part as it has control over it.
3. To raise exchange rate:
a) Decrease supply of foreign exchange => increase supply of rupee
b) Increase in demand of foreign exchange => fall in demand for rupee
Govt will follow a part)