Foreign Exchange rate

Meaning - Foreign exchange refers the currency of all the countries other than the domestic
country. In other words for the people of Indonesia all the currencies other than Rupiah are
termed as foreign exchange.
For the topic we will assume foreign as ‘Dollar’

Foreign Exchange Rate – It refers to the rate at which the currency of one country is exchanged
with the currency of other country.
Foreign exchange rate measures the number of units of one currency required to exchange with
one unit of other currency.
Example $ 1 = 14569.50 Rupiah as on 6th Aug 2020.

Currency depreciation – It refers to the decrease in the value of domestic currency in terms of
foreign currency. It makes the domestic currency less valuable and hence more of it is required
to buy foreign currency.

Example – OLD RATE - $ 1 = 14215 Rupiah

NEW RATE - $ 1 = 15215 Rupiah
Effect of depreciation of domestic currency on export:
Depreciation of the domestic country implies that the foreign country can purchase more
amounts of goods and services with the same amount of their currency.
It makes the exports from domestic currency cheaper and hence export increase.

Currency appreciation - It refers to increase in the value of domestic currency in terms of

foreign currency. The domestic currency becomes more valuable and hence less of it is required
to buy the same amount of foreign currency.

Example – OLD RATE - $ 1 = 15215 Rupiah

NEW RATE - $ 1 = 14215 Rupiah
Effect on imports- Due to appreciation the domestic country can purchase more amounts of
foreign goods with the same amount of money.
It makes imports of domestic country cheaper than earlier and hence imports increases.

Types of foreign exchange rates

1. Fixed exchange rate system (pegged exchange rate system) – It refers to a system in
which exchange rate of a currency is determined by the government.The basic purpose of
adopting this system is to ensure stability in foreign trade and capital movements.
Under this system, the domestic country keeps the value of its currency fixed in terms of
some external standard.This external standard can be gold, silver or it could be currency
of any other country or any other thing.

2. Flexible exchange rate system – It refers to a system in which exchange rate is

determined by the forces of demand and supply of different currencies in the foreign
maket i.e the currency which is in demand, has higher exchange rate and the currency
whose supply is more, less valuable and hence it is exchanged at a lower rate.
The value of currency is allowed to fluctuate freely.

3. Managed exchange rate system – It is hybrid(combination) of fixed and flexible

exchange rate system. It refers to a system in which foreign exchange rate is determined
by the forces of demand and supply and central bank is a key participant to stabilize the
rate of currency in case of extreme appreciation and depreciation.

Demand of foreign exchange

Demand of foreign exchange(dollar)arises due to many reasons, some of which are as follows:
1. Foreign exchange is demanded for making payment of imports of goods and services
from the foreign country.
2. Foreign exchange is required to undertake foreign tour.
3. Foreign exchange is required for purchasing asset in foreign country.
4. Foreign exchange is required to make unilateral transfer (one sided transfers like sending
gifts) to abroad.
5. Demand arises when people wants to make gain from the appreciation of currency.
 DEMAND CURVE OF FOREIGN EXCHANGE
The demand curve of foreign exchange slopes negatively from left to right as there exist negative
relationship between rate and demand of foreign exchange. i.e if rate of foreign exchange (rate of
dollars in terms of Rupiah) increase its quantity demand decreases and vice versa.

SUPPLY OF FOREIGN EXCHANGE

1. Supply of foreign exchange(dollar) comes from export and import of goods and
services.
When we export goods or services to some foreign country, they make payments
in their own currency(dollar) and hence the supply increases.

2. When some foreign company or individual invest in domestic country it leads to

increase in supply of foreign exchange as they invest in there own
currency(dollar).

3. Supply of foreign exchange increases in the form of gifts from abroad or

foreigners undertake tour in domestic country.
 REASONS FOR RISE IN SUPPLY OF FOREIGN EXCHANGE

1. When rate of foreign exchange rises, domestic goods become cheaper. It induces
the foreign country to increase their imports from domestic country. And for
making payments of imports they supply their own currency (dollar) and hence its
supply increases.
2. When price of foreign currency rises, its supply also increases as people wants to
make gains from speculative activities.
Explanation – people who earlier purchase foreign currency (dollar) at a lower rate will now sell
them at higher price and earn profit.

SUPPLY CURVE OF FOREIGN EXCHANGE

The supply curve of foreign exchange slopes upwards as there is positive relationship between
rate of foreign exchange and its supply i.e if rate of foreign exchange increases(rate of dollar in
terms of Rupiah) then its quantity supplied also increases and vice versa.
 DETERMINATION OF EXCHANGE RATE

The equilibrium exchange rate is determined at the level at which the demand of foreign
exchange is equal to the supply of foreign exchange.

The equilibrium exchange rate is determined in the above diagram.

When the rate of foreign exchange is OP2 its quantity demanded is greater then quantity supplied
at point d which is known as excess demand.
So in order to get the point of equilibrium (point E) the rate of foreign exchange must increase
(rate of dollars in terms of Rupiah).
Similarly, when the rate of foreign exchange is OP1 the quantity supplied is greater then the
quantity demanded at point b which is known as excess supply.
In order to reach equilibrium and to minimize the condition of excess supply the exchange rate
must be decreased.

FOREIGN EXCHANGE MARKET

Meaning - It is the market also called forex in which foreign currencies are bought and sold.
Like any other market, foreign exchange market is a system not a place.
The transaction in this market are not restricted to some specific currencies. In fact there are
large number of foreign currencies which are traded in this market.Buyer can be individual ,
firms, banks or any other institution.
 FUNCTION OF FOREIGN EXCHANGE MARKET

1. Transfer functions- It transfers purchasing power between the countries involves in the
situation This function is performed through credit instruments like bills of foreign
exchange, bank drafts, and telegraphic transfer.
2. Credit functions – It provide credit facility for foreign trade. Bills of exchange with
maturity period of 3 months are generally used for international payment.