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Unit 4: Exchange Rate and Its Economic Effects Chapter Notes | Business Economics for CA Foundation PDF Download

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Unit 4: Exchange Rate and Its Economic Effects Chapter Notes | Business Economics for CA Foundation

Introduction

Every day, we come across intriguing news about currency fluctuations, such as the Rupee strengthening against the US dollar or changes in Dollar Spot/Forward Rates. Have you ever wondered what these terms mean? In this unit, we will explore some fundamental concepts related to currency transactions.

In a previous chapter, we discussed the demand for and supply of domestic currency. However, it is not just domestic currency that is needed. Households, businesses, and governments in India purchase various goods and services produced in other countries. Similarly, people from other countries buy goods and services from India. Foreign investors, businesses, and governments also invest in India, just as Indian nationals invest in other countries. International lending and borrowing occur in the same way. These transactions create an international aspect of money, which involves exchanging one currency for another. Naturally, this requires market transactions to determine the price of one currency in terms of another.

The Exchange Rate

A foreign currency transaction refers to any transaction that involves a foreign currency, either in terms of denomination or settlement. This includes various scenarios such as:

  • Buying or Selling Goods or Services: When an enterprise engages in the purchase or sale of goods or services, and the price is specified in a foreign currency.
  • Borrowing or Lending Funds: In cases where the amounts to be paid or received are denominated in a foreign currency.
  • Entering into a Forward Exchange Contract: Becoming a party to an unperformed forward exchange contract involves a commitment to exchange currencies at a future date, and this falls under the purview of foreign currency transactions.
  • Acquiring or Disposing of Assets: This includes situations where an enterprise acquires or disposes of assets, or incurs or settles liabilities, and these transactions are denominated in a foreign currency.

Question for Chapter Notes- Unit 4: Exchange Rate and Its Economic Effects
Try yourself:
Which of the following scenarios is NOT considered a foreign currency transaction?
View Solution

Understanding Exchange Rate Regimes

Exchange rates are essentially the value of one currency in terms of another, and they are primarily determined by the demand and supply of different currencies. However, governments can play a significant role in influencing these exchange rates through various means. The level and nature of government involvement in the currency markets give rise to different systems of exchange rates. In this section, we will explore some common exchange rate systems and their macroeconomic implications.

There are three broad categories of exchange rate systems:

  • Free-Floating Exchange Rate: In this system, exchange rates are determined solely by private market forces without any government intervention. The values of currencies change constantly based on the fluctuating demand and supply.
  • Managed Float Exchange Rate: In this system, currency values are allowed to change, but governments actively participate in the currency markets to influence those values.
  • Fixed Exchange Rate: In this system, governments seek to fix the values of their currencies either through active participation in the market or through regulatory policies.

An exchange rate regime refers to the way a country manages its currency in relation to foreign currencies. It determines how the value of the domestic currency is set in terms of foreign currencies. The two major types of exchange rate regimes at the extreme ends are:

  • Floating Exchange Rate Regime: Also known as a flexible exchange rate, in this system, governments and central banks do not intervene in the foreign exchange market. The relationship between these institutions and the currency markets is similar to that between them and the stock markets. While governments may regulate stock markets to prevent fraud, stock values are allowed to float in the market.
  • Fixed Exchange Rate Regime: In this system, governments actively fix the value of their currencies, either through market intervention or regulatory policies.

Advantages of Free-Floating Exchange Rate:

  • Free-floating exchange rate system has the advantage of being self-regulating. There is no need for government intervention if the exchange rate is left to the market. Market forces also restrain large swings in demand or supply. 
  • For instance, if there is a sudden increase in demand for Canadian goods and services, it would lead to a higher demand for Canadian dollars, raising Canada’s exchange rate. 
  • This increase in exchange rate would make Canadian goods and services more expensive for foreign buyers, thus absorbing some of the impact of the increased foreign demand. In this way, a free-floating exchange rate acts as a buffer, insulating an economy from the effects of international events.

Fixed and Managed Float Exchange Rate Systems

Free-Floating Exchange Rates:

  • The main challenge with free-floating exchange rates is their unpredictability. Contracts between buyers and sellers in different countries must consider not only potential changes in prices and other factors but also the possibility of exchange rate fluctuations.
  • For instance, an agreement between an Indian distributor and a U.S. supplier for the purchase of goods could be impacted by changes in the exchange rate between the Indian rupee and the U.S. dollar during the contract period.
  • These fluctuating exchange rates add an extra layer of risk to international transactions, making them more uncertain and increasing the overall cost of doing business with other countries.

Managed Float Systems:

  • In a managed float system, governments and central banks attempt to influence their exchange rates by buying or selling their own currencies. While exchange rates are allowed to float, these authorities intervene to sway their values.
  • Countries with a floating exchange rate system occasionally intervene in the currency market to raise or lower the value of their currency, aiming to prevent sudden and drastic fluctuations.
  • For example, if a country’s currency is rapidly appreciating, its government or central bank might intervene to prevent excessive appreciation, which could harm net exports.
  • Such interventions, while sometimes effective, typically have a limited impact on exchange rates.

Fixed Exchange Rates:

  • In a fixed exchange rate system, the government sets the exchange rate between two currencies. Various mechanisms can maintain these fixed rates.
  • Despite differences in maintenance methods, all fixed exchange rate systems share key characteristics, such as stability and predictability in currency values.

Fixed Rate Regime

  • Currency Stability:. fixed exchange rate ensures stability by eliminating fluctuations, which reduces exchange rate risks and transaction costs. This stability facilitates smoother international trade and investments.
  • Risk Reduction: Under a fixed rate regime, profits are not influenced by exchange rate fluctuations, making international trade and investment less risky.
  • Trade and Investment Boost:. fixed exchange rate can significantly enhance international trade and investment by providing a stable environment.
  • Speculation Reduction:. fixed rate reduces speculation on exchange rate movements, as it creates a perception that exchange rates will remain constant.
  • Inflation Control:. fixed exchange rate system imposes discipline on a country’s monetary authority, making it more likely to maintain lower levels of inflation.
  • Encouraging Trade and Investment: Stability under a fixed rate encourages greater trade and investment, as it fosters a conducive environment for businesses.
  • Credibility Enhancement: An exchange rate peg can enhance the credibility of a country’s monetary policy, instilling confidence among investors and traders.
  • Intervention Requirement: In fixed or managed floating exchange rate regimes, central banks must be prepared to intervene in the foreign exchange market and maintain adequate foreign exchange reserves for this purpose.

Floating Exchange Rate Regime

  • Independence in Monetary Policy:. floating exchange rate allows a central bank and government to pursue independent monetary policies without being tied to a fixed exchange rate.
  • Policy Tool Flexibility: Policymakers can use the nominal exchange rate as a tool to influence the competitiveness of the tradable goods sector, adjusting it to suit economic conditions.
  • Reduced Foreign Exchange Reserves: Since there is no obligation to intervene in currency markets, central banks do not need to maintain large foreign exchange reserves, reducing the burden on monetary authorities.
  • Transparency and Efficiency:. floating exchange rate is considered efficient and transparent, as it reflects supply and demand for foreign exchange in the market, clearing imbalances without central bank intervention.
  • Stability vs. Flexibility: While a fixed rate offers stability and credibility, it lacks flexibility. In contrast, a floating rate provides greater policy flexibility but at the cost of stability.

Nominal vs Real Exchange Rates

Nominal Exchange Rate:

  • The nominal exchange rate refers to the rate at which one currency can be exchanged for another, indicating the value of one currency in terms of another.
  • Different nominal exchange rates exist for a single currency because it can be exchanged for various foreign currencies. Economists often use indexes to average these multiple exchange rates into a single measure of a currency's international value.
  • While nominal exchange rates can help determine the domestic price of foreign goods, trade flows are more influenced by real exchange rates. This is because buyers are more concerned with what they can purchase with the foreign currency rather than just the exchange rate itself.

Real Exchange Rate:

  • The real exchange rate represents the value of goods and services in one country relative to those in another country, indicating how many units of a good or service in one country can be traded for one unit of the same good or service in a foreign country.
  • It is a crucial factor in determining a country's net exports of goods and services.
  • To calculate the real exchange rate, especially when trading a single good, the nominal exchange rate is used to convert prices into a common currency. The real exchange rate (RER) is then calculated by multiplying the nominal exchange rate by the ratio of prices between the two countries.
  • The formula for calculating the real exchange rate is: 
    Real Exchange Rate = (Nominal Exchange Rate) x (Domestic Price) / (Foreign Price)
  • Alternatively, it can be expressed as: 
    Real Exchange Rate = Nominal Exchange Rate x (Domestic Price / Foreign Price)
  • This calculation shows that the real exchange rate depends on both the nominal exchange rate and the prices of goods in the two countries, measured in their local currencies.
  • When analyzing the economy as a whole, price indices measuring the cost of a basket of goods and services are used. In this case, the real exchange rate is calculated as: 
    Real Exchange Rate = Nominal Exchange Rate x Domestic Price Index / Foreign Price Index

Real Effective Exchange Rate (REER)

  • The Real Effective Exchange Rate (REER) is derived from the nominal effective exchange rate, which measures the value of a domestic currency against a weighted average of various foreign currencies.
  • REER is calculated by dividing the nominal effective exchange rate by a price deflator or an index of costs.
  • An increase in REER indicates that a country's exports become more expensive and imports become cheaper, signifying a loss in trade competitiveness.

Question for Chapter Notes- Unit 4: Exchange Rate and Its Economic Effects
Try yourself:
What exchange rate system allows currencies to fluctuate based on market forces without government intervention?
View Solution

The Foreign Exchange Market

Participants in the Forex Market:

  • Commercial Banks:. Execute orders from various clients, including exporters, importers, and investment institutions. - Engage in trading operations for their own interests and profit, often making billions in daily turnover. - Play a significant role in speculative operations with currency.
  • Brokerage Houses:. Act as intermediaries between banks, funds, and other market players. - Influence the price formation process and market activity by setting their own prices.
  • Passive Players:. Include entities like exporters, importers, and investors who cannot set their own quotations. - Engage in activities such as hedging currency risks, foreign investments, and tourism.

Types of Transactions in the Foreign Exchange Market:

  • Current Transactions:. Conducted in the spot market with immediate delivery. - Involve spot exchange rates, which are applicable for transactions settled within two days.
  • Future Transactions:. Involve agreements to buy or sell currencies for future delivery. - Conducted in forward and futures markets.

Forward Exchange Rates:

  • Forward exchange rates are similar to spot rates but involve future delivery of currencies.
  • A forward premium occurs when the forward rate is higher than the spot rate, while a forward discount occurs when the forward rate is lower.

Currency Futures:

  • Currency futures serve a similar purpose as currency forwards but differ in settlement and delivery details.

Foreign Exchange Transaction Vehicle Currency:
In a foreign exchange transaction, any two currencies can be involved. However, most transactions typically involve exchanging foreign currencies for U.S. dollars. This occurs even when the dollar is not the national currency of either the importer or exporter. Due to its crucial role in the forex markets, the U.S. dollar is often referred to as a "vehicle currency."

Determination of Nominal Exchange Rate

The nominal exchange rate of a country is determined by the supply and demand for foreign exchange in the domestic foreign exchange market.

Demand for Foreign Currency Individuals and institutions demand foreign currency for various reasons, including:

  • Purchasing goods and services from another country
  • Making unilateral transfers such as gifts, awards, grants, donations, or endowments
  • Making investment income payments abroad
  • Purchasing financial assets, such as stocks or bonds, abroad
  • Opening a foreign bank account
  • Acquiring direct ownership of real capital
  • Engaging in speculation and hedging activities related to risk-taking or risk-avoidance

Supply of Foreign Currency The supply of foreign currency to the home country results from various activities, including:

  • Purchases of home exports
  • Making unilateral transfers to the home country
  • Investment income payments to the home country
  • Foreign direct investments and portfolio investments in the home country
  • Placement of bank deposits in the home country
  • Speculation activities

Foreign Exchange Market Dynamics:

  • The foreign exchange market operates similarly to any standard market, with a downward-sloping demand curve and an upward-sloping supply curve.
  • The interplay of supply and demand in this market determines the exchange rate, which reflects the external value of the domestic currency.Unit 4: Exchange Rate and Its Economic Effects Chapter Notes | Business Economics for CA Foundation

The nominal exchange rate is established through the balance of supply and demand for a specific foreign currency. When the demand for a currency matches its supply, the nominal exchange rate is set.

Changes in Exchange Rates

Changes in exchange rates reflect the depreciation or appreciation of one currency against another.

Currency Appreciation:

  • Currency appreciation occurs when the value of a currency increases relative to another currency or a basket of currencies.
  • For example, if the exchange rate changes from $1 = ₹70 to $1 = ₹65, the Indian Rupee has appreciated against the US Dollar.

Currency Depreciation:

  • Currency depreciation happens when the value of a currency decreases relative to another currency or a basket of currencies.
  • Using the same example, if the exchange rate changes from $1 = ₹70 to $1 = ₹75, the Indian Rupee has depreciated against the US Dollar.

Home-Currency Depreciation:

  • Home-currency depreciation, also known as foreign-currency appreciation, occurs when there is an increase in the home currency price of foreign currency.
  • This means it takes more of the home currency to purchase one unit of foreign currency, making the home currency relatively less valuable.

Home-Currency Appreciation:

  • Home-currency appreciation, or foreign-currency depreciation, takes place when there is a decrease in the home currency price of foreign currency.
  • This indicates that it takes less of the home currency to purchase one unit of foreign currency, making the home currency relatively more valuable.

Floating Rate System:

  • Under a floating rate system, if the demand for foreign currency increases (shifting the demand curve to the right) while the supply remains unchanged, the exchange value of foreign currency rises.
  • This results in the depreciation of the domestic currency.

Question for Chapter Notes- Unit 4: Exchange Rate and Its Economic Effects
Try yourself:
What is the term used to describe the situation when the value of a currency increases relative to another currency or a basket of currencies?
View Solution

Home-Currency Depreciation under Floating Exchange Rates

Initial Equilibrium

  • The market starts at equilibrium point E with an exchange rate of eeq.

Increase in Demand for Foreign Currency

  • When there is an increase in the domestic demand for foreign currency (dollars) while the supply of dollars remains constant, the demand curve shifts right to D1$.
  • This shift causes the equilibrium exchange rate to rise to e1, indicating that more Indian Rupees are needed to buy one dollar.
  • As a result, the Indian Rupee depreciates against the dollar.

Increase in Supply of Dollars

  • Now, let’s consider what happens when there is an increase in the supply of dollars in the Indian market. This is illustrated in the next figure.
  • An increase in the supply of foreign currency (dollars) shifts the supply curve to the right to D1$.
  • Consequently, the exchange rate declines to e1, meaning that fewer Indian Rupees are required to buy one dollar.
  • This indicates that the Indian Rupee appreciates against the dollar.

Unit 4: Exchange Rate and Its Economic Effects Chapter Notes | Business Economics for CA Foundation

Importance of Exchange Rates in an Open Economy

  • In an open economy, exchange rates play a crucial role in translating foreign prices into domestic currency.
  • They allow for the comparison of prices for goods and services produced in different countries.
  • Exchange rates also facilitate the expression of import and export prices in the same currency within trading contracts.
  • This is why movements in exchange rates can significantly impact international trade flows.

Devaluation (Revaluation) vs Depreciation (Appreciation)

  • Devaluation refers to a intentional decrease in the value of a country's currency compared to another currency, a group of currencies, or a standard. It is a tool used in monetary policy by countries with a fixed or nearly fixed exchange rate. Devaluation involves an official reduction in the fixed par value of a currency, set by the monetary authority.
  • For example, if Country A devalues its currency against the US dollar, the fixed rate might change from 1 A = 1 B to 1 A = 0.8 B, making A less valuable compared to B.
  • Depreciation, on the other hand, occurs when a currency's value decreases due to market forces of supply and demand under a floating exchange rate system. This change is not influenced by government or central bank actions. For instance, if the demand for Country A's currency falls in the global market, its value may depreciate from 1 A = 1 B to 1 A = 0.9 B.
  • Revaluation is the opposite of devaluation. It involves an official increase in the fixed par value of a nation's currency. For example, if Country A revalues its currency, the fixed rate might change from 1 A = 1 B to 1 A = 1.2 B, making A more valuable compared to B.
  • Appreciation is when a currency's value increases due to market forces under a floating exchange rate. This increase is not a result of government or central bank interventions. For instance, if the demand for Country A's currency rises in the global market, its value may appreciate from 1 A = 1 B to 1 A = 1.1 B.

Effects of Exchange Rate Fluctuations on the Domestic Economy

Introduction: Exchange rates are one of the most closely watched and analyzed economic indicators because they play a crucial role in the economy. Fluctuations in exchange rates can create unpredictability in the markets, which can significantly impact a country's economic performance. Understanding how exchange rate fluctuations affect the economy is essential, especially for developing countries. In this discussion, we will explore the impact of exchange rate fluctuations on the real economy.

Direct and Indirect Effects:

  • Developments in the foreign exchange markets can affect the domestic economy both directly and indirectly. The direct impact of fluctuations in exchange rates is initially felt by economic agents involved in international trade or finance.

Role in Trade:

  • Fluctuations in the exchange rate play a significant role in determining the nature and extent of a country's trade. They affect the relative prices of domestically produced and foreign-produced goods and services.

Currency Appreciation:

  • When a country’s currency appreciates, it raises the relative price of its exports and lowers the relative price of its imports. This means that foreign consumers pay more for the country’s products, while domestic consumers pay less for foreign products.

Currency Depreciation:

  • Conversely, when a country’s currency depreciates, it lowers the relative price of its exports and raises the relative price of its imports. This makes exports cheaper for foreign consumers and imports more expensive for domestic consumers.

Example: Indian Rupee:

  • For instance, if the Indian Rupee depreciates from 65 Rupees to 70 Rupees per US dollar, a foreigner spending ten dollars on Indian goods would receive goods worth 700 Rupees instead of 650 Rupees.
  • Similarly, an Indian importer would have to pay 70 Rupees for a dollar’s worth of goods instead of 65 Rupees.

Impact on Importers and Exporters:

  • Importers would be most affected by this depreciation, as they would need to pay more Rupees to import goods.
  • On the other hand, exporters would benefit because they would receive more Rupees for the same amount of dollars when selling goods abroad.

Economic Activity and Currency Depreciation:

  • Exchange rate changes can significantly impact economic activity in the domestic economy. A depreciation of the domestic currency increases the price of foreign goods relative to domestically produced goods.
  • This shift in relative prices encourages consumers to shift their spending from foreign goods to domestic goods.

Expansionary Impact:

  • Increased demand for domestic import-competing goods and exports stimulates economic activity and leads to output expansion.
  • Overall, currency depreciation has an expansionary impact on the economy, provided that the demand shift occurs in the right direction and to the right extent.

Capacity to Meet Increased Demand:

  • The positive effect of currency depreciation also depends on the home economy's capacity to meet the increased demand by supplying more goods.

(i) Impact on Exports and Employment

  • A depreciated currency can be highly beneficial for economies with strong export sectors.
  • When exports come from labor-intensive industries, higher export prices resulting from currency depreciation can positively influence employment and potentially lead to wage increases.

(ii) Consumer Price Inflation

  • Depreciation is likely to contribute to consumer price inflation in the short term.
  • This occurs directly through the impact on prices of imported consumer goods and indirectly due to increased demand for domestic goods.
  • The effect is more pronounced if the domestic consumption basket contains a higher proportion of imported goods.
  • Additionally, cost-push inflation may arise from the escalation in the cost of imported inputs.

(iii) Central Bank Policy

  • In an inflationary scenario resulting from depreciation, the central bank is unlikely to lower policy rates.
  • Lowering rates in such a situation could exacerbate the financial burden on various borrowers, including businesses.

(iv) Fiscal Health and Current Account Balance

  • The fiscal health of a country experiencing currency depreciation is influenced by rising export earnings and import payments, impacting the current account balance.
  • A widening current account deficit poses a risk to the growth prospects of the overall economy.
  • Conversely, if export earnings outpace import spending, the current account balance will improve.

(v) Impact on Companies with Foreign Currency Loans

  • Companies that have borrowed in foreign currency through external commercial borrowings (ECBs) and have not adequately hedged these loans against foreign exchange risks may face negative consequences.
  • A depreciated domestic currency increases the amount of domestic currency needed to repay these loans, raising the debt burden and impacting profits and balance sheets adversely.
  • This situation can deter investors from putting money into such companies.

(vi) Countries with Foreign Currency Denominated Government Debts

  • Currency depreciation can escalate the interest burden on governments with foreign currency denominated debts, straining their ability to repay and service these obligations.
  • However, India has a relatively small proportion of public debt in foreign currency, mitigating this risk.

(vii) Financial Forecasting and Exchange Rate Risks

  • Exchange rate fluctuations complicate financial forecasting for firms, necessitating larger allocations for insuring against exchange rate risks through hedging.

(viii) Significance of Exchange Rates in International Investments

  • With the growth of cross-border investments, exchange rates have become increasingly significant.
  • Investors holding foreign assets or corporations issuing foreign debt face foreign exchange risks due to exchange rate movements.
  • These fluctuations are now a crucial factor influencing the value of international investments, affecting business volumes, profit forecasts, investment plans, and outcomes.
  • A depreciating currency can negatively impact investor sentiments and significantly alter patterns of international capital flows.

Impact of Currency Appreciation on the Economy

Foreign Investment and Capital Inflows:

  • High exchange rate volatility makes foreign investors cautious.
  • A weakening local currency deters foreign capital inflows, affecting foreign portfolio investments in debt and equity, as well as foreign direct investments.
  • This leads to increased capital account deficits, negatively impacting fiscal health.

Trade Settlements in National Currencies:

  • To reduce fiscal deficits, countries like Russia and India have started trade settlements in national currencies.
  • This shift aims to boost trade volumes and improve fiscal conditions.

Russia-India Trade Dynamics:

  • Trade turnover between Russia and India has increased, with plans for further growth.
  • Russian exports to India currently exceed imports, despite fluctuations in currency values.

Currency Appreciation Effects:
Exports and Imports:

  • Currency appreciation makes exports more expensive, potentially reducing their quantity.
  • Conversely, imports become cheaper, likely increasing their quantity.

Aggregate Demand and Economic Growth:

  • The combination of reduced exports and increased imports leads to a decline in domestic aggregate demand, negatively impacting economic growth.

Business Cycle Considerations:

  • The impact of currency appreciation varies depending on the business cycle stage.
  • During a recession, appreciation can further decrease aggregate demand and increase unemployment.
  • In a booming economy, it can alleviate inflationary pressures and moderate growth rates.

Inflation and Living Standards:

  • Currency appreciation can reduce inflation levels by making imports cheaper.
  • Lower prices for imported capital goods, components, and raw materials decrease production costs, leading to lower prices.
  • Additionally, decreased aggregate demand helps lower demand-pull inflation.
  • Living standards may improve due to the availability of cheaper consumer goods.

As export prices rise, the competitiveness of domestic industries suffers. In response, firms are more motivated to adopt technological innovations and shift towards capital-intensive production methods to reduce costs and stay competitive.

Impact on Current Account

  • Increasing imports and declining exports can lead to larger deficits and worsen the current account.
  • However, the effect of currency appreciation on the current account depends on the elasticity of demand for exports and imports.
  • If the demand for imports and exports is relatively inelastic, there may be an improvement in the current account position.
  • Conversely, if the price elasticity of demand for exports is high, a stronger currency could lead to a significant decline in export demand, negatively impacting the current account balance.

Competitiveness and Currency Appreciation

  • The loss of competitiveness due to currency appreciation is negligible if the appreciation is driven by the strong fundamentals of the economy.
  • Countries generally prefer stable exchange rates to mitigate the risks and uncertainties associated with international trade and investments.
  • However, nations may occasionally opt for trade-offs, such as a weaker exchange rate to boost exports and aggregate demand or a stronger exchange rate to combat inflation.

Conclusion

It is essential for individuals to stay informed about contemporary exchange rate developments and their implications for the economic welfare of countries.

The document Unit 4: Exchange Rate and Its Economic Effects Chapter Notes | Business Economics for CA Foundation is a part of the CA Foundation Course Business Economics for CA Foundation.
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FAQs on Unit 4: Exchange Rate and Its Economic Effects Chapter Notes - Business Economics for CA Foundation

1. What is the difference between nominal and real exchange rates?
Ans. The nominal exchange rate refers to the rate at which one currency can be exchanged for another without adjusting for inflation. In contrast, the real exchange rate takes into account the relative price levels of the two currencies, adjusting the nominal rate for inflation and providing a more accurate measure of a currency's purchasing power in comparison to another currency.
2. How do floating exchange rates differ from fixed exchange rates?
Ans. Floating exchange rates are determined by the market forces of supply and demand relative to other currencies, allowing for fluctuations based on economic conditions. In contrast, fixed exchange rates are pegged to another major currency or a basket of currencies and are maintained by the government or central bank through interventions in the foreign exchange market.
3. What factors lead to changes in exchange rates?
Ans. Changes in exchange rates can be influenced by various factors, including differences in interest rates, inflation rates, political stability, economic performance, and market speculation. Additionally, changes in supply and demand for currencies can cause fluctuations in exchange rates.
4. What is the impact of home-currency depreciation under floating exchange rates?
Ans. Home-currency depreciation under floating exchange rates can make exports cheaper and more competitive in international markets, potentially boosting export-driven economic growth. However, it can also lead to higher import costs, increasing inflation and potentially reducing the purchasing power of consumers.
5. What is the significance of the foreign exchange market in determining exchange rates?
Ans. The foreign exchange market is crucial in determining exchange rates as it is where currencies are traded. The interactions of buyers and sellers in this market establish the price of currencies based on supply and demand dynamics. It facilitates international trade and investment by providing a mechanism for currency conversion.
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