Notesale: Turn your study into money

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CH
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For example
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are foreign exchange from the view point of India
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(For eg
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45)
System or Types of Exchange Rates
There are two broad concepts:
(A) Fixed Exchange Rate System
❖ Meaning
• It is the rate which is officially fixed by the government or financial authority
of the country
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But under fixed exchange rate system basically there are two concepts
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By considering
gold value of each country exchange rate could be determined
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50 = 200 gm of gold = $I=Rs
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70 = 200 gm of gold = $I= Rs
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Different currencies were pegged to one currency i
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US$
b
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c
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d
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❖ Merits
(i) Stability

It ensures stability in the exchange market or international money market
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It helps in formulation of long term economic
policies (relating to exports and imports)
(ii) Encourages International Trade
This is because this system implies low risk and low uncertainty for future
payments
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❖ Demerits
(i) Huge international reserves
This system is often supported with huge international reserves of gold
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Accordingly, international growth process suffers
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(iii) Discourages venture capital
Fixed exchange rate discourages venture capital in the international money
market
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(iv) Rigidity in resource allocation
Fixed exchange rate imparts rigidity to the allocation of reserves particularly in
the area of international trade
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• Here value of currency is allowed to fluctuate or adjust freely according to
change in demand and supply of foreign exchange
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Determination of Flexible Exchange Rate or Equilibrium Exchange Rate
• According to this theory, the rate of exchange of a country's currency is
determined by the demand and supply of foreign exchange
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Foreign
exchange is demanded by domestic residents for the following reasons
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(ii) To purchase financial assets (to invest in bond equity share in a foreign
country)
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(iv) To make payments of international trade (imports)
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(vi) To speculate on the value of foreign currencies
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• There is an inverse relationship between price of foreign exchange (exchange
rate) and demand for foreign exchange
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That is why; demand curve for
foreign becomes downwards sloping
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• Following factors cause supply of foreign exchange
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(ii) Direct foreign Investment (when foreigners invest in the bonds and
equity shares of the home country)
(iii) Direct purchase of the goods and services by the non residents in the
domestic market
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(v)

Remittances (gifts & grants or transfer payments) by the non-residents
living in the rest of the world or foreign countries
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When exchange rate rises, supply of
foreign exchange also rises and vice versa
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❖ Diagram

❖ Equilibrium Exchange Rate
• Equilibrium exchange rate is determined at a point where demand for and
supply of foreign exchange are equal
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❖ Diagram

• In the diagram, demand curve and supply curve of dollars (foreign exchange)
intersect each other at the point E which implies that at the exchange rate of
OR, quantity demanded and quantity supplied is equal to EQ
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Change in Exchange Rate (Depreciation and Appreciation of Currency)
(a) Depreciation of Indian Currency (Increase in the demand for Us $ in India)
• Suppose exchange rate is I$= Rs
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An increase in India's demand for US $
will cause the demand curve DD shift to D1D1 the resulting intersection will
be at a higher rate
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60)
• It shows depreciation of Indian currency (Rs
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• Thus depreciation of a currency means fall in its value in terms of another
foreign currency (domestic currency is relatively less valuable)
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It means one $
can be exchanged for more rupee
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It means exports to USA have become
cheaper
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(b) Appreciation of Indian currency (Increases in supply of US $)
• Suppose exchange rate is I$= Rs
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An increase in the supply of US $ will
cause the supply curve SS shift to S1S1
• The resulting intersection will be at a lower exchange rate
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40)
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) because les currency (rupee)
(40 instead of 50) are required to buy I US $
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Quantity of foreign exchange ($)
❖ Effect of Appreciation of Domestic Currency on Imports
Appreciation of domestic currency means a rise in the price of domestic
currency (say rupee) in terms of a foreign currency (say $ in means one rupee
can be exchanged for more $
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It means imports from USA have
become cheaper
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The effect of
devaluation is the same as that of depreciation of the currency
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The effect of
revaluation is the same as that of appreciation of currency
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foreign currency by market
forces
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forces of demand and supply
of foreign exchange
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exchange rate system
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(ii) Optimum Resource Allocation
• It enhances efficiency in resource allocation
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(iii) Venture Capital
• Flexible exchange rate system promotes venture capital in the foreign
exchange market
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(iv)International Capital Movement
• Flexible exchange rate enhances movement of capital across different
Countries of the world
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(ii) Discourages International Trade
• Instability in the foreign exchange market causes instability in the area of
international trade
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(iii) Macroeconomic Policies
• Coordination of macroeconomic policies become more difficult due to dayto-day fluctuation in exchange rate
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• Central bank does not have absolute power but some power to manage
exchange rate slightly according to the economy
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It
is a system that allows adjustments in exchange rate according to a set of rules
and regulations which are officially in foreign exchange market
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There is no
predefined range of adjustments and also there is no pre-defined time of
adjustments
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It is
for managing authority to allow or reject an appeal for adjustment
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Foreign Exchange Market
❖ Meaning
• The market in which national currencies of various countries are converted,
exchanged or traded for one another is called foreign exchange market
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It includes banks, specialized
foreign exchange dealers, brokers and official govt
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• A market where foreign currencies are bought and sold
• It is a centre of trade of different currencies of different countries of the world
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(i) Spot Market
(ii) Forward Market

(i) Spot Market
• The market in which the receipts and payments of foreign exchange are made
immediately, is called spot market
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❖ Functions of Foreign Exchange Market
(i)
Transfer Function

It implies transfer of purchasing power in terms of foreign exchange across
different countries of the world
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(iii)

Hedging Functions
In implies protection against the risk related to variations in foreign exchange
rate (demand for and supply of foreign exchange is committed at some
commonly agreed rate of exchange even when the commitments are to be
honoured on some future date)

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