Meaning of Foreign Exchange Rate
Foreign exchange, for a Country A, refers to all the currencies, other than the local currency of Country A. Foreign exchange rate refers to the rate at which one unit of currency of a country, can be exchanged for the number of units of currency of another country.
For Example, currently : $ 1 = Rs. 73 . This means that Rs. 73 can be exchanged for $ 1 .
Foreign exchange rate is the price of a currency expressed in terms of another currency. Foreign exchange rate fluctuate from day to day, and are determined by the forces of demand and supply.
Types of Exchange Rate
Three main types of exchange rate systems are as under :
- Fixed Exchange Rate System ;
- Flexible Exchange Rate System ; and
- Managed Floating.
Fixed Exchange Rate
Fixed Exchange Rate refers to rate of system of exchange, which is officially declared and fixed by the Government of a country.
In earlier times, FER had two important variants : –
(a) Gold Standard System of Exchange Rate ;
(b) Bretton Woods System Adjustable Peg System of Exchange Rate.
Gold Standard System of Exchange Rate : According to this system each country was to define value of its currency in terms of gold. Value of one currency in terms of the other currency was fixed considering gold value of each currency.
IF 1 UK ₤ = 10 gm of Gold and 2 US =10 gm of Gold, then 1 UK ₤ = 2 US .
The Bretton Woods System : Under this system A two – tier system of convertibility was established based on the dollar. US monetary authorities guaranteed the convertibility of the dollar into gold at the fixed price of $ 35 per ounce of gold. The second-tier of the system was commitment of monetary authority of each IMF member participating the system to convert their currency into dollars at a fixed price.
Merits of Fixed Exchange rate
- Stability in Exchange rate enables stability in foreign trade ;
- It promotes capital movements because a stable currency does not involve any uncertainties about exchange rate that may cause capital loss.
- Prevents speculation in foreign exchange market.
- It forces the Government to keep inflation in check.
Demerits of Fixed Exchange rate
- FER contradicts the key objectives of free markets ;
- Countries with deficits in balance of payment run down their stock of gold and foreign currencies. Forced which can them to devalue their currency.
- There may be undervaluation or overvaluation of currency.
Flexible Exchange Rate
Flexible rate of exchange is that rate which is determined by the demand for and supply of the currencies concerned in the foreign exchange market.
R = f (D, S)
R = Exchange Rate
D = Demand for different currencies in the international market
S = Supply of different currencies in the international market.
Exchange rate at which demand for foreign currency is equal to its supply is called Par Rate of Exchange, Normal Rate or Equilibrium Rate.
Merits of flexible exchange rate
- Eliminates problem of overvaluation or undervaluation currencies, deficit or surplus in balance of payments.
- The Government is not required to hold any reserves.
- Enhances efficiency in economy by optimum resource allocation.
Demerits of flexible exchange rate
- It creates instability and uncertainty as wide fluctuations in exchange rate are possible.
- It encourages speculation leading to larger uncertainties and fluctuations.
- Currency fluctuations can discourage international trade and investment.
In Managed Floating system, the foreign exchange rate system is determined by the market forces of demand and supply, and the Central Bank intervenes and influences the foreign exchange rate in the market.
The difference between the Managed Floating and flexible (or floating) exchange rate is that floating exchange rate is determined forces of demand and supply of foreign exchange and there is no official intervention.
Demand for Foreign Exchange
The main sources of demand for foreign exchange are as under : –
(a) Purchase goods and services from other countries by the domestic residents. For example, a lot of people in India import electronic goods from China.
(b) Send gifts and grants to foreign countries. For example, gifts to relatives
(c) Speculate on the value of foreign currencies
(d) Invest and purchase financial assets in other country – For example, purchase of shares of Apple Inc., by a person resident in India
(e) Make payments of international loans- For example, loan given by an Indian company to its subsidiary
There is an inverse relation between foreign exchange rate and demand for foreign exchange. Higher the foreign exchange rate, the lower would be its demand , and lower the foreign exchange rate, the higher would be the demand for foreign exchange.
Supply of Foreign Exchange
The main sources of supply for foreign exchange are as under : –
(a) Foreigner’s purchasing domestic country’s goods and services through exports – For example, lots of foreigners purchase Indian handmade goods.
(b) Direct foreign investment in the domestic country – For example, purchase of shares of Flipkart buy Walmart
(c) Flow of foreign exchange due to speculative purchases by the non – residents in the domestic country
(d) Remittances by the non – residents living abroad – For example, indian residents working abroad may send money to their parent
There is a direct relation between foreign exchange rate and supply of foreign exchange. Higher the exchange rate, higher the supply of foreign exchange and lower the exchange rate, lower the supply of foreign exchange.
Equilibrium Rate of Exchange
The flexible exchange rate is determined at a point where the ‘demand for’ and ‘supply of’ foreign exchanges are equal.
The point where demand and supply of foreign exchange intersect each other, is called Par Value of Exchange or point of equilibrium
Depreciation and Appreciation of Domestic Currency
Depreciation of Domestic currency
If the demand for foreign exchange (say UK pound sterling ) increases, supply schedule remaining the same, the exchange rate will rise. A rise in exchange rate implies appreciation of the UK pound sterling (or depreciation of the Indian rupees).
Increase in exchange rate implies that more rupees are needed to buy one UK pound sterling , or in other words, that Indian rupee is depreciating.
Appreciation of Domestic Currency
If the supply of foreign exchange (say UK pound sterling) increases, demand schedule remaining the same, the exchange rate will fall. A fall in the exchange rate implies appreciation of the Indian rupees (or depreciation of the UK pound sterling.)
The fall in exchange rate implies that less rupees are needed to buy one UK pound sterling, or in other words, that Indian rupee is appreciating.