Foreign Exchange Rate

Introduction
 Foreign exchange market is where money denominated in one currency is bought and sold
with money denominated in another currency

 Exchange rate refers to the rate at which the currencies of different countries are traded
or exchanged

 The exchange rate can be defined in either of the two ways:

i) The number of units of domestic currency that exchanges for one unit of foreign currency.

1$ = Rs 50

ii) The number of units of foreign currency that exchanges for one unit of domestic currency.

Rs1= 0.2$
 Exchange Rate System
 There are two major exchange rate systems- fixed and flexible exchange rate

 Fixed Exchange rate: the rate of exchange is officially fixed by the central bank
of country.

 Such a rate doesn’t vary with changes in demand and supply of foreign currency

 Central bank intervenes in the foreign exchange market in the form of buying and
selling of currency. Central bank has to hold reserves of foreign currencies

 When there is excess supply of foreign exchange central banks buys foreign
currencies and when sale it when there is excess demand
 Flexible exchange rate system: exchange rate is left free to be determined in the
foreign exchange market by the forces of demand and supply. It is also known as
floating exchange rate

 Floating exchange rate system can be of two types- clean floating, managed
floating

 In clean floating, central bank stands aside completely and allows exchange rate
to be freely determined in the foreign exchange market

 In managed floating central bank intervenes to buy and sell foreign currencies in
an attempt to influence the exchange rate
 Appreciation of currency
 1$ = Rs 40

Rupees has appreciated

 1$= Rs 30

 The VALUE of currency has increased, because earlier we purchase something

worth of $1 by giving them ₹40. Now after changes, we just need to give ₹ 30
for $1 good. So we can buy more of goods. Which result in increase in imports.

 Other way round is: value of currency has increased, so foreign has to pay more
to buy same goods, our goods become expensive to purchase.
Depreciation & Devaluation of currency
 1$ = Rs 40

Rupees has depreciated

 1$= Rs 50
 Depreciation refers to fall in the free- market value of domestic currency
relative to the currencies of the other countries in the foreign exchange market.
 Devaluation refers to an action undertaken by the central bank to decrease the
value of domestic currency relative to the currencies of other countries. (under
fixed exchange or semi-fixed exchange rate)
Determination of exchange rate under
flexible system
 Under this system the equilibrium rate of exchange is determined by the
forces of demand and supply
 Assumption: that there are two countries : India & USA and rate of exchange
is determined by the demand for and supply of American dollars, which is the
only foreign currency
 Demand for foreign exchange ( dollars): Imports of Goods & Services,
Purchase of assets abroad etc.
 Demand for foreign exchange is inversely proportional to exchange rate
 If dollar changes from 1$= Rs 60 to 1$=Rs 50, the exchange rate has decreased
and now Indian demand for American dollar would increase because American
goods have become cheaper now
 Supply of Foreign Exchange: Exports of goods , when foreign tourists visits
India etc.
 Supply for foreign exchange varies directly with the exchange rate

S
D
Exchange rate (rupees per $)

D>S = dollar appreciates

S>D= rupees appreciate

D
S
S

Demand and Supply of dollars