Chapter 13 - Foreign Exchange Rate - Chapter Notes, Macro Economics, Class 12 - Commerce PDF Download

FOREIGN EXCHANGE RATE

FOREIGN EXCHANGE :: It refers to all currencies other the domestic currency of a given country.
For example, India’s domestic currency is Indian Rupee and all other currencies like US Dollar, British Pound, Kuwaiti Dinar, etc. are foreign exchange.

FOREIGN EXCHANGE RATE :: It refers to rate at which one unit of currency of a one country can be expressed // exchanged for the number of units of currency of another country .

Thus it is the price of a country’s currency in terms of another country’s currency and thus represents external value or EXTERNAL PURCHASING POWER OF DOMESTIC CURRENCY. It can be represented as

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(a) US $ 1 = Rs.50 ( one American dollar can be exchanged for 50 Indian Rupee )
(b) Rs 1 = 1 / 50 Dollar = 2 Cents (one Indian rupee can be exchanged for 2 Amercian cents

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TYPES

(A) FIXED EXCHANGE RATE :: It means that rate of exchange which is OFFICIALLY FIXED (or pegged ) in terms of gold ( or any other currency ) by the government and adjusted only infrequently . Thus it has two variants

MERITS OF FIXED EXCHANGE RATE SYSTEM

(1) It ensures STABILITY in international money market by avoiding day to day fluctuations.
(2) It implies low risk and low uncertainty and thus ENCOURAGE INTERNATIONAL TRADE
(3) It helps in FORMULATION of long term economic policies especially related to exports and
imports and COORDINATION OF MACRO POLICIES in different countries of the world.
(4) It PREVENTS CAPITAL OUTFLOW and and thus prevent speculation
(5) It PREVENTS MAJOR ECONOMIC DISTURBANCES in the member country .
(B) FLEXIBLE EXCHANGE RATE // FLOATING RATE :: It is the rate which
is determined BY THE DEMAND FOR AND SUPPLY OF THE CURRENCIES in the foreign exchange market.

R = f ( D , S )

 Thus in this value of currency is allowed to fluctuate or adjust freely according to change in Demand for and supply of Foreign currency. There is no official intervention by Central Bank of the country .

The exchange rate is called as Par Rate oF Exchange and is Equilibrium rate.

MERITS OF FLEXIBLE EXCHANGE RATE // FLOATING RATE

(1) There is NO NEED TO MAINTAIN INTERNATIONAL RESERVES for the government
(2) It provides EFFICIENCY IN RESOURCE ALLOCATION in an optimum way and thus
improves efficiency
(3) It INCREASES MOVEMENT OF CAPITAL across different countries of the world as no
huge reserves are to be maintained
(4) It PROMOTES VENTURE CAPITAL (investment in foreign exchange to earn profit.
(5) There is no problem of undervaluation or overvaluation of currency. Deficit or Surplus BOP is automatically corrected under this system

(C) HYBRID SYSTEM OF EXCHANGE RATE :: Those system which are neither fully Fixed systems nor fully flexible systems.
These are often referred to as ALTERNATIVE SYSTEM OF EXCHANGE RATE which combine the merit of both Fixed and flexible system of exchange rate. Some of these
system are
(1) WIDER BAND :: Wider band is a system that ALLOWS WIDER ADJUSTMENT in the fixed exchange rate system.
Acc. to this system a country
- specifies a parity value for its currency and
- allows adjustment upto 10 % around parity between any two currencies.

E.g :: if 1$ = Rs.50 , Exchange rate may be revised as 1$ = Rs.55 or 1$ = Rs.45.

This is to help the member countries to correct their BOP (balance of payments) status. In the event of deficit BOP, India, for example, may depreciate its currency (upto 10 per cent). This is expected to increase demand for India’s products. Accordingly, BOP status is expected to improve.

(2) CRAWLING PEG :: It is a system that ALLOWS SMALL BUT REGULAR ADJUSTMENT in the exchange rate for different currencies
Acc. to this system a country
- specifies a parity value for its currency and
- Not more than ( + ) 1% is allowed at a time around parity between any two currencies.
E.g :: if 1$ = Rs.50 , Exchange rate may be revised as 1$ = Rs.50.5 or 1$ = Rs.49.5.

(3) MANAGED FLOATING :: Under this system , the exchange rate is managed or controlled by the GOVERNMENT OR MONETARY AUTHORITY . Thus it is a system of gradual adjustment in the exchange rate by a central bank to influence the value of its own currency in relation to other currency.

AIM :: Under this system, which is not supported by any international agreement , the central banks manage to intervene in the international exchange market with a view to keep the exchange rate within desired limit

RELATED TO :: One of concept related to managed floating is DIRTY FLOATING which refers to situation when managed floating is exercised without caring for the rules and regulations . Thus Dirty Floating results in manipulation ofexchange rate against the interest of other country.
Example :: Keeping Domestic currency value low so that domestic good continue to remain cheap and have more export

WORKING OF MANAGED FLOATING :: It is through the sale and purchase of foreign currency in the international money market .
Suppose the Central Bank realises that the market value of rupee is heavily depreciating
against US dollar

Central bank would sell US dollars in the international money market from its reserves

Increase in supply of US dollar in the market is expected to reduce the price of dollar in
relation to the domestic currency ( rupee)

Such an action helps to restore the value of rupee in international market

FOREIGN EXCHANGE MARKET :: It refers to market where National currencies of various countries are converted, exchanged and traded for one another i.e buying and selling of foreign exchange takes place.
It is not any physical place but is a network of communication system which connects the whole complex of institution and includes ommercial bank, Brokers , Official govt. agencies , Foreign exchange dealers

FUNCTIONS OF FOREIGN EXCHANGE MARKET

(1) TRANSFER FUNCTION :: It implies transfer of purchasing power in terms of foreign exchange across different countries of the world
(2) CREDIT FUNCTION :: It implies provision of credit for the export and import of goods and services.
(3) HEDGING FUNCTION :: It implies PROTECTION AGAINST THE RISK related to change in foreign exchange rate in near future.Demand and Supply of foreign exchange is committed at some commonly AGREED RATE OF EXCHANGE even when transaction is to be take place at some future date.Thus it is an activity designed to minimise risk of loss
DEMAND FOR FOREIGN EXCHANGE :: There is an INVERSE RELATION between foreign exchange rate and demand for foreign currency and hence DEMAND CURVE IS DOWNWARD SLOPING

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SOURCES / DEMAND FOR FOREIGN EXCHANGE

(a) Purchase of goods and services from ROW i.e Import
(b) Payment of international loans
(c) Gifts and grants to ROW
(d) Investment in ROW for financial assets ( like shares , bonds) and real assets (building , shop)
(e) To speculate on value of Foreign currencies
(f) To undertake foreign tour and for foreign education
(g) Remittances by foreigners working in the country to their families abroad

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DEMAND FOR FOREIGN CURRENCY AND EXCHANGE RATE
 (PRICE OF FOREIGN CURRENCY)

SUPPLY FOR FOREIGN EXCHANGE :: There is an POSITIVE RELATION between foreign exchange rate and supply of foreign currency. Hence supply curve is UPWARD SLOPING

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SOURCES / SUPPLY OF FOREIGN EXCHANGE

(a) Sale of goods and services to ROW i.e Export
(b) Borrowing From IMF,World Bank and Foreign Govt.
(c) Gifts and grants from ROW
(d) Investment in home country through Joint ventures and financial market operation
(e) To speculate by non-resident in domestic T.
(f) Foreigner undertake tour of domestic country
(g)Remittances by resident abroad to their families in domestic territory

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SUPPLY FOR FOREIGN CURRENCY AND EXCHANGE RATE
 (PRICE OF FOREIGN CURRENCY)

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CHECK YOUR CONCEPT’S

(Ques) Sate whether the following items constitute demand or supply of foreign exchange :
(i) Indian going to USA for medical treatment.
(ii) Donation of 500 Million $ received from Microsoft.
(iii) Import of goods from China.
(iv) Indian students going to Australia for MBA.
(v) Foreign Tourists to India to visit Taj Mahal.
(vi) Purchase of land in England.
(vii) Bought 500 Pounds to sell for speculation.

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DETERMINATION OF FOREIGN EXCHANGE RATE (FLEXIBLE )

The theory of determination of rate of exchange is the Demand and Supply theory.It is the rate which is determined BY THE DEMAND FOR AND SUPPLY OF THE CURRENCIES in the foreign exchange market.

R = f ( D , S )

Thus in this value of currency is allowed to fluctuate or adjust freely according to change
in Demand for and supply of Foreign currency. There is no official intervention by Central
Bank of the country .

The exchange rate is called as Par Rate oF Exchange and is Equilibrium rate

There is an inverse relation between foreign exchange rate and demand for foreign currency and hence Demand curve is downward sloping
There is an positive relation between foreign exchange rate and supply of foreign currency. Hence supply curve is Upward sloping .

D and S of foreign currency is measured on the OX-axis and rate of exchange on OY-axis.DD and SS
interest at point ‘E’ and thus OR is equilibrium rate of exchange.
If rate is OR1 there will be excess supply of foreign currency by ‘AB’ amount and this will cause rate of
exchange to come down to OR
If rate is OR2 there will be excess demand of foreign currency by ‘MN’ amount and this will cause rate
of exchange to rise to OR

BOP REFLECTS SUPPLY AND DEMAND FOR FOREIGN CURRENCY
 DISEQUILIBRIUM SITUATIONS

(1) UNFAVOURABLE BOP :: means country receipts is less than payment and hence demand for foreign currency will increase from DD to D1D1 and will cause exchange rate to rise to OR1 (let say 1 $ = Rs.55).This cause more domestic currency is to be paid for one unit of foreign currency.which means the value of domestic currency in terms of foreign currency falls. This is called CURRENCY’S DEPRECIATION.
 

(2) FAVOURABLE BOP : means country receipts is more than payment and hence supply of foreign currency will increase from SS to S1S1 and will cause exchange rate to fall to OR2 (let say 1 $ = Rs.45).This cause less domestic currency is to be paid for one unit of foreign currency which means the value of domestic currency in terms of foreign currency rises .This is called CURRENCY’S APPRECIATION.

CURRENCY DEPRECIATION VS CURRENCY APPRECIATION

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CHECK YOUR CONCEPT’S

(Ques) In the following cases, indicate which currency is appreciating and which one is depreciating :

(a) A change from 3 $ = 2 £ to 4 $ = 2 £ .
(b) A change from Rs. 95 = 2 US $ to Rs.150 = 3 US $.
(c) A change from Rs.140 = 2 to Rs. 60 = 1 £ .
(d) A change from Rs. 25 = 1 Singapore $ to Rs. 20 = 1 Singapore $.
(e) $ 3 = Rs 1 to $ 2 = Rs 1

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