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Foreign Exchange Rate

This document discusses foreign exchange rates and systems. It defines foreign exchange as any currency other than the domestic currency. There are two main types of exchange rate systems - fixed and flexible. Fixed exchange rates are officially determined by the government while flexible rates are determined by market forces of supply and demand. The equilibrium exchange rate is where demand and supply of foreign currency are equal. The document also discusses currency devaluation, revaluation, depreciation and appreciation.

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373 views8 pages

Foreign Exchange Rate

This document discusses foreign exchange rates and systems. It defines foreign exchange as any currency other than the domestic currency. There are two main types of exchange rate systems - fixed and flexible. Fixed exchange rates are officially determined by the government while flexible rates are determined by market forces of supply and demand. The equilibrium exchange rate is where demand and supply of foreign currency are equal. The document also discusses currency devaluation, revaluation, depreciation and appreciation.

Uploaded by

Disha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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FOREIGN EXCHANGE

Any currency other than the domestic currency .

Foreign Exchange Rate

The rate at which one currency exchanges for the other currency
in the foreign exchange market .
OR Foreign exchange rate is the price of a foreign currency in
terms of domestic currency

SYSTEM OF EXCHANGE RATE


Fixed exchange rate and Flexible exchange rate
Fixed Exchange Rate
In fixed exchange rate system, the rate of exchange is officially
fixed or determined by Government or Monetary Authority of the
country.
• .Merits of Fixed Exchange Rate
(i) Stability in exchange rate
(ii) Promotes capital movement and international trade.
(iii) No scope for speculation.
• Demerits of Fixed Exchange Rate
(i) Need to hold foreign exchange reserves.
(ii) No automatic adjustment in the 'Balance of payments'
(iii) Enhance dependence on external sources
.Flexible or Floating Exchange Rate
In a system of flexible exchange rate (also known as floating
exchange rates), the
exchange rate is determined by the forces of market demand and
market supply of foreign exchange.
• The demand of foreign exchange have inverse relation with
flexible exchange rate. If flexible exchange rate rise the
demand of foreign exchange falls and Vice versa.
• Sources of Demand for Foreign Exchange
(a) To purchase goods and services from the rest of world.
(b) To purchases financial assets (i.e., to invest in bonds and
equity shares) in a foreign country.
(c) To invest directly in shops, factories, buildings in foreign
countries.
(d) To send gifts and grants to abroad.
(e) To speculate on the value of foreign currency.
(f) To undertake foreign tours.

• The supply of foreign exchange have positive relation with


foreign exchange rate. If foreign exchange rate rises the
supply of foreign exchange rate also rises and vice versa.
• Source of Supply of Foreign Exchange
(i) Direct purchase by foreigners in domestic market.
(ii) Direct investment by foreigners in domestic market.
(iii) Remittance by non-residents living abroad.
(iv) Flow of foreign exchange due to speculative purchases
by N.R.I.
(v) Exports of goods and services.
1
• Merits of Flexible Exchange Rate
(i) No need for the govt to hold foreign exchange reserves
(ii) Leads to automatic adjustment in the 'balance of payments'.
(iii) To increase the efficiency in the economy by achieving
optimum resource allocation.
(iv) To remove obstacles in the transfer of capital and trade.
• Demerits of Flexible Exchange Rate
(i) Fluctuations in future exchange rate.
(ii) Encourages speculation.
(iii) Discourages international trade and investment.

Determination of Equilibrium Foreign Exchange Rate :


• Equilibrium foreign exchange rate is the rate at which
demand for and supply of foreign exchange are equal.

• Under free market situation, it is determined by market


forces i.e., demand for and supply of foreign exchange.

• There is inverse relation between demand for foreign


exchange and exchange rate. Due to above reasons
demand curve downward sloping .

• There is direct relationship b/w supply of foreign exchange


and exchange rate.
Due to above reasons supply curve is upward sloping
curve

• Graphically intersection of demand Curve and supply curve


determines the equilibrium foreign exchange rate.

Devaluation of a Currency :

• When government or monetary authority of a country


officially lowers the external value of its domestic currency
(in respect of all other foreign currency) is called devaluation
of a currency.

• It takes place by government order under fixed exchange


rate system.
2
Revaluation of a Currency :
• When government or monetary authority of a country officially
raises the external value of its domestic currency (in respect
of all other foreign currency) is called revaluation.

• It takes place by government order under fixed exchange


rates system.

Currency depreciation

There is a fall in the value of domestic currency, in term of foreign


currency due to change in demand and supply of the currency
under flexible exchange rate system.

Currency appreciation

There is a rise in the value of domestic currency in terms of


foreign currency due to change in demand and supply of the
currency under flexible exchange rate system.

Managed floating system

• This system is a combination of fixed and flexible exchanges


rates.

• It is a system in which the central bank allows the exchange


rate to be determined by market forces but intervenes at
times to influence the rate.

• When central bank finds the rate is too high, it starts selling
foreign exchange from its reserve to bring down it.
• When it finds the rate is too low. It starts buying to raise the
rate.

Multiple Choice Question

1. In currency depreciations, there is


(a) Fall in the value of domestic currency in term of foreign Currency
(b) No change in the value of domestic currency
(c) Rise in the value of domestic currency in terms of foreign Currency
(d) Decrease in the production of goods in domestic country.

2. Major functions of foreign exchange market are


(a) International transfer of foreign currency
(b) Providing credit for foreign trade
(c) Hedging foreign exchange rate
(d) All of the above

3. Buyers and Sellers of foreign exchange are


(a) Central Bank (b) Commercial Bank
(c) Brokers (d) All the above

4. Which one country manipulates exchange rate against the interest of


other country, is known as
(a) Managed floating (b) Dirty floating
(c) Wide band (d) Crawling peg.

5. How exports are affected during appreciations of currency?


(a) Increases (b) Decreases
(c) Remains constant (d) None of the above.
6.Other things remaining unchanged, when in a country the price of foreign
currency
rises, national income is : ( choose the correct alternative)
(a) Likely to rise
(b) Likely to fall
(c) Likely to rise and fall both
(d) Not affected

7.Other things remaining the same, when in a country the market price of foreign
currency falls, national income is likely : (Choose the correct alternative)
(a) to rise
(b) to fall
(c) to rise or to fall
(d) to remain unaffected

SHORT ANSWER TYPE QUESTIONS (3-4 MARKS)


1. For the given exchange rates state which currency is appreciating
and which one is depreciating
Old Exchange New Exchange Appreciating Depreciating
Rate Rate Currency Currency
1£ = $1 1 £ = $2 – –
1€ = 3$ 1€ = 2$ – –
1HK$ = Rs. 20 1HK$ = Rs. 18 – –
1US$ = 100¥ 1US$ = 102¥ – –
2. Give three reasons why people desire to have foreign exchange.
3. Give any three/four sources of supply of foreign exchange.
4. Explain the relationship between foreign exchange rate and demand for it.
5. Explain the relationship between foreign exchange rate and supply of foreign
exchange.
6. Explain the terms 'appreciation and depreciation of currency.'
7. Explain the merits and demerits of fixed exchange rate.
8. Explain the merits and demerits of flexible exchange rate.
4
9. Higher the foreign exchange rate, lower the demand for foreign exchange.
Explain why?
10. Lower the foreign exchange rate, higher the demand for foreign exchange.
Explain why?
11. Explain the impact of Devaluation of domestic currency on the export and
imports of an economy.
12. Give the meaning of fixed, flexible and managed floating exchange rate.
13. Why the demand for foreign exchange falls when the foreign exchange rate
rises explain with the help of an example.
14. How can increase in foreign direct investment affect the price of foreign
exchange ?
15 .Recently govt of India had doubled the import duty on gold .What impact was
it likely to have on foreign exchange rate and how?
16.Why does the demand for foreign currency fall and supply rises when its price
rises ? Explain.
17.

18. Define “Trade surplus”. How is it different from “Current account surplus” ?
19 Differentiate between Autonomous &Accommodating Items.
20. Differentiate between BOP on current account & capital account.
21. Differentiate between BOP & BOT.
22. State the Items included in BOP account.
5

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