Foreign Exchange Rate

Introduction
• Exchange rate is the rate at which one country’s currency is exchanged for
another. Or we can say that it is the price of one currency in terms of other
currencies.
• An exchange rate of Rs. 157 = $1 means that one dollar is exchanged for Rs.
157
• The exchange rate for any currency is determined either by the monetary
authorities (government and central bank) or by the forces of demand and
supply of that currency in open foreign exchange market.
• The Equilibrium rate of exchange under free market is the rate at which
demand for foreign currency equals supply of the same.
 Example
• In case of exchange rate between dollar and rupee, the demand for dollars
comes from the Pakistani importers who have rupees with them and want
to get dollars for importing goods.
• On the other hand, supply of dollar comes from those Pakistani Exporters
who have got dollars by exporting goods. They want to exchange dollars for
rupees to run their business in Pakistan.
• If Pakistani importers demand more dollars than what Pakistani exporters
have earned, then the price of dollar will start rising.
• A higher dollar price will discourage demand for dollars and will encourage
exporters to supply more dollars. At some rate demand and supply of dollars
will be equal. This will be equilibrium exchange rate.
 Determination of Free Exchange Rate
• When exchange rate is allowed to float freely, the value of one currency in
terms of others determined by the market forces of demand and supply.
• Demand for foreign currency comes from those who want to import
something from foreign countries or want to invest abroad.
• Supply of foreign currency comes from those people who have exported
something to other countries.
 Fixed and Floating Exchange Rate
• Fixed exchange rate:
• Under this system, the rate of local currency against foreign currencies is
fixed by the monetary authorities of the country. All transactions take place
at that rate.
• Flexible or floating exchange rate:
• It is determined by the free working of the forces of demand and supply of
foreign exchange. If there is excess supply of some currency, its value in
foreign exchange market falls (depreciates).
• On the other hand, shortage of foreign currency will raise the rate
(appreciate). The monetary authorities (central bank or govt.) do not
interfere.
 Case For Fixed Exchange Rate
• Fixed exchange rate encourages international trade since prices of goods
exported or imported are predictable.
• Fixed exchange rate encourages long term capital inflow or outflow in a smooth
manner. For example, the foreign investors in Pakistan will not be worried
because of any uncertainty or risk arising from frequent changes in exchange
rate.
• There is no fear of any adverse effect of speculation on exchange rate because
monetary authorities prevent speculation activities. (Speculation means that
people hold or sell foreign exchange to take advantage of the expected changes
in the rate in future.
• Fixed exchange rate compels the monetary authorities to follow a disciplined and
responsible policy. If the fixed exchange rate is to be maintained. Internal policy
creating inflation or deflation will be avoided.
 Case Against Fixed Exchange Rate
• Its makes difficult for a government to freely make internal economic
policies. If govt. tries to reduce unemployment by increasing money
supply, prices of exported good rise. Due to less exports exchange rate
tends to fall. They govt. does not allow this. So the government will not
be able for reduce unemployment gold and inflation.
• Large reserve of foreign currencies are required to maintain fixed
exchange rate. If there is deficit in the balance of payments and the
demand for foreign currencies increase, then the government will have
to provide the extra amount of foreign exchange, otherwise the rates of
exchange will rise.
• Fixed exchange rate encourages black market in foreign
currencies. It happened in Pakistan during 60s and 70s
when Pakistan followed fixed exchange rate.
• Exchange rate cannot be fixed forever conditions about
exports and imports are never constant. Need to devalue or
revalue currency arises frequently.
• Fixed exchange rate requires strict exchange control
measures. But such step may not be successful and black
market of foreign exchange may come up. This will lead to
mal-allocation of resources and corruption.
 Case For Floating Exchange Rate
• The system is simple to operate. Exchange rates moves up or down
automatically and freely to equalize demand and supply of foreign currencies.
• Exchange rate adjusts itself according to the conditions in exchange markets.
The change is smooth, whenever demand for a foreign currency starts rising
exchange rate starts moving up.
• Under flexible exchange rate, the govt. can independently follow any domestic
policy about prices and employment. Exchange rate may rise or fall.
• The need for keeping huge amounts of foreign exchange to support and maintain
the fixed rate is removed.
• There will be no need for borrowing form IMF to correct disequilibrium in
balance of payments. Changes in exchange rate automatically brings
equilibrium.
 Case Against Floating Exchange Rates
• The system is suitable only if money and exchange markets are perfect. In
Pakistan, these markets do not works perfectly. There are monopolies and
other influences which create wrong signals about demand and supply
position. For example, a sudden rise in exchange rate may not mean that the
country’s exports have fallen (rather it may be due to the fact that people are
transferring capital outside the country because of political instability).
• It is difficult to follow a truly flexible exchange rate policy because internal
monetary and fiscal measures influence the rate. So if other countries are
adversely affected by the policies of a government, they may retaliate.
• Frequent changes in exchange rate create risks for importers and exporters
due to uncertainty, the international trade may be badly affected
• Flexible exchange rate encourages speculation in foreign
exchange market. Some people start hoarding (or
dishoarding foreign exchange) because they expect
changes in rates.
• It encourages inflation, the value of currencies of
developing countries like Pakistan continuously fall and
push up the price level in the country.
• Pakistan is presently following the system of managed
floating exchange rate. State bank of Pakistan tries to keep
exchange rate within acceptable limits. It buys or sells
foreign currencies in open market.
Depreciation of The Currency

• Depreciation is the falling of external value of currency (say

Rupees) in free foreign exchange market. Depreciation of a
currency can occur if the government allows free float of
exchange rate and the demand for foreign currency rises. (or
supply of foreign currency falls)
Devaluation of The Currency

• Devaluation is the decrease in external value of a

currency (say Rupees) announced by the government.
This happens when the country follows policy of
fixed rate. (if the authorities raise the value, it is
revaluation)