9. Foreign Exchange Rate: Meaning and Determination
Foreign exchange rate: It is the price of one currency in terms of another. It is the rate at which exports and imports of a country are valued at given point in time.
Importance of foreign exchange rate:
1. A country’s economic stability is indicated, among other things, by the stability in its exchange rate.
2. The strength of domestic currency is seen against that of currencies of other countries in the world.
3. Earnings from exports and payments for imports are directly affected by the exchange rate.
Foreign exchange market: It is the market where national currencies are traded for one another.
Foreign exchange market performs three main functions. They are:
1) to transfer purchasing power between countries (transfer function)
2) to provide credit channels for foreign trade (credit function) and
3) to protect against foreign exchange risks (hedging function)
Demand for foreign exchange is the demand for foreign currencies by the residents of a country. Similarly, supply of foreign exchange is the demand for home country currency by the non-residents of the country.
Demand and supply side
People’s intention to transact in the foreign exchange market depends upon their demand and supply position with respect to foreign exchange.
Demand side: Demand for foreign exchange depends upon the following factors.
1) to purchase goods and services from other countries
2) to send gifts abroad
3) to purchase financial assets abroad and
4) to speculate on the value of foreign currencies.
Supply side: Flow of foreign currencies into the country depends upon the following.
1) foreigners purchasing home country’s goods and services through exports.
2) foreign investment in the home country through joint ventures or through financial market operations and
3) foreign currency flow into the economy due to currency dealers and speculators
Equilibrium in the foreign exchange market
Foreign exchange market, like any other market contains a downward sloping demand curve and an upward sloping supply curve. The price on the Y-axis is stated in terms of domestic currency (that is, how many rupees for one dollar). The horizontal X-axis measures the quantity demanded and supplied of foreign exchange (say, US $).
The intersection of demand and supply curves determines the equilibrium exchange rate and the equilibrium quantity of the foreign currency.
The demand curve (D$) is downward sloping. It means that less foreign exchange is demanded as the exchange rate increases. This is because the rise in the price of foreign exchange will increase the rupee cost of foreign goods, which makes them more expensive. As a result, imports decline. Thus, the demand for foreign exchange will also decrease.
The supply curve (S$) is upward sloping which means that supply foreign exchange increases as the exchange rate increases. This makes home country’s goods become cheaper to foreign since the rupee is depreciating in value.
Disequilibrium conditions in the foreign exchange market: An increase in the demand for US dollars in India
An increase in the demand for US dollar will cause the demand curve to shift to D’$ and the exchange rate increases. Increase in exchange rate means that more rupees are required to buy one US dollar. Fall in the value of Indian rupee in terms of foreign currency is called depreciation. In this case, domestic currency is less valuable.
Similarly, an increase in the supply of US dollars will cause the supply curve shift to S’$ and exchange rate falls to R. In this case, rupee cost of US dollar is decreasing and the Indian rupee is said to be appreciating. Rise in the value of rupee in terms of foreign currency is called appreciation. In this case, domestic currency is more valuable.
Types of exchange rate systems
The determination of foreign exchange depends upon specific international arrangement of procedure to determine the exchange rate of one country vis-à-vis others.
Fixed exchange rate systems
Under this system, exchange rate is officially declared and it is fixed. Only a very small deviation from this value is possible. A typical fixed exchange rate system was associated with the Gold Standard Systems of 1880 – 1914.
Under the Gold Standard Systems, value of each currency was fixed 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 par value of exchange.
For example, if one Indian Rupee is exchangeable for 125 grams of fine gold and the US dollar for 25 grams of fine gold, then one Rupee is equal to 125/25 = 5 US dollars. So, the price is fixed at Re.1=$5.
Adjustable Peg System
Since the gold standard failed to automatically correct the disequilibrium in countries’ balance of payments, an alternate system of fixed exchange rate called Breton Woods system was established in 1944.
Under this arrangement, the US dollar was made directly convertible into gold at a fixed price. Member countries fixed their exchange rates as against the dollar.
The Breton Woods system was an adjustable peg system. The member countries were required to fix the parity of their currencies with gold. A change in the parity was possible only through a direction from the IMF. This system is modified version of fixed exchange rate system but the role of gold as ultimate unit of parity was preeminent.
Advantages of fixed exchange rate system
1. Fixed exchange rates ensure that major economic disturbances which will weaken the economic policies of member countries.
2. Fixed exchange rates contribute to the coordination of macro policies of countries in an interdependent world economy.
3. Fixed exchange rates are more conducive to expansion of world trade as they prevent risk and uncertainty in transactions.
Flexible exchange rates system:
Flexible exchange rates point to an extreme situation where there is no intervention by central banks. The foreign exchange market is busy at all times by changes in the exchange rates. In this system exchange rate is determined by the interaction of demand for and supply of foreign exchange.
Advantages of flexible exchange rate system
1. Flexible exchange rates eliminate the need for central banks to hold international reserves.
2. Flexible exchange rates are helpful to do away with barrier to trade and capital movements.
3. Flexible exchange rates enhances the efficiency in the economy by achieving optimum resources allocation.
Operation of foreign exchange market
Foreign exchange markets could be studied in terms of period of transaction carried out. If the operation is of daily nature, it is called current market or spot market. On the other hand, market for foreign exchange for future delivery is known as forward market.
Spot market for foreign exchange: Spot rate of foreign exchange is used for current and daily transactions. The strength of the domestic currency with respect to all of the home country’s trading partners is measured by the average relative strength of the home country’s currency. It is known as Effective Exchange Rate (EER). Since the effect of price changes is not eliminated, it is also called as Nominal Effective Exchange Rate (NEER).
If the domestic country (India
NEER =
Forward market for foreign exchange: Most of the international transactions are signed one day and the actual transactions take place at a much later date. In the forward market, payments are made on the basis of as and when the actual transactions take place. This is done in order to hedge against (avoid) risks.
A forward contract is entered into for two reasons.
One is to minimize the risk of loss due to adverse change in exchange or two, to earn profit that may arise due to change in exchange rates.
Difference Between Fixed Exchange Rate System and Flexible Exchange Rate System
| Fixed Exchange Rate System | Flexible Exchange Rate System |
| Value of a currency against another foreign currency is fixed by the Govt. | Value of the currency against another foreign currency is fixed through the interaction of the market forces of demand and supply of foreign currency. |
| Value of the currency is stable. | Value of currency is fluctuating. |
| Due to stability in value, foreign trade is promoted. | Due to instability and uncertainty international trade is hampered. |
| It promotes capital movements. | It hampers capital movements. |
| Discourages/no scope for speculation. | Encourages speculation |
| There can be over valuation or under valuation. | No over valuation or under valuation. |
| To correct any imbalance of payments the central bank uses the official reserves. | Automatic correction of imbalances takes place |
| Govt. has a role to play to correct imbalance in Balance of Payments. | Govt. is free from any Balance of Payments problems. |
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