unit-5foreignexchangerate-200516173747.pdf
- 1. Unit – 5 (6 Marks) Chapter-1 Foreign Exchange Rate
- 3. Introduction ● In a modern set up of today’s world, all countries have economic relations with other countries. There is increasing interdependence among all countries. ● As each country has its own currency, domestic currency of a country cannot be used directly in any other country. It has to be converted into currency of the other country and then to be used in transactions.
- 4. Meaning of Foreign Exchange Foreign Exchange It refers to the stock of: (a) Foreign currencies (b) Securities and bonds issued by foreign corporates and government.
- 5. • The rate at which currency of one country is exchanged for the currency of other country is known as foreign exchange rate. • It is the price of one currency in terms of another. • It represents the external purchasing power of a currency. It is the rate at which exports and imports of a nation are value at a given point of time. Meaning of Foreign Exchange Rate
- 6. Types of Foreign Exchange Rate System (A) Fixed Exchange Rate System • It is the system in which the rate of exchange for a currency is officially fixed by the government. Under this system, government is responsible to stabilize the exchange rate. • Under this system, each country maintains value of its currency fixed in terms of gold, silver, other precious metal, another country’s currency etc. • There are two systems of fixed exchange rate:- (i) Gold standard system of exchange rate (ii) The Bretton Woods System
- 7. (i) Gold standard system of fixed exchange rate According to this system, gold was taken as the common unit of parity between currencies of different countries. Each country defined value of its currency in terms of gold. For example, if 1₤ (U.K. Pound) = 2 g of gold and 1$ (U.S. Dollar) = 1 g of gold then exchange rate would be 1 U.K. ₤ = 2 U.S $.
- 8. (ii) Bretton Woods System/ Adjustable Peg System – This system was adopted to have transparency in the system. Under this system, all currencies were related to US dollar which ultimately was convertible into gold. • IMF worked as central institution in controlling the system. • It is called ‘adjustable peg system’ because it allowed some adjustments but only if allowed by IMF.
- 9. Merits of Fixed Exchange Rate (i) It ensures stability in the exchange market. (ii) It implies low risk and low uncertainty for future payments. (iii) Coordination of macroeconomic policies across different parts of the world becomes convenient. (iv) It prevents speculation in foreign exchange market. Demerits of Fixed Exchange Rate (i) Government has to maintain 100% gold reserves. (ii) It restricts the movement of capital across different parts of the world. Since exchange rate is fixed, investment is also fixed and the international growth suffers. (iii) There is possibility of under or over valuation of the currency. (iv)It does not encourage venture capital.
- 10. Flexible/ Floating Exchange Rate System • It is the system of exchange rate in which exchange rate between currencies of different countries is determined by the market forces of demand and supply. • There is no official interference by the Govt. in the foreign exchange market. • It is called flexible because it tends to change with changes in market forces of demand and supply. • The exchange rate at which demand for foreign currency is equal to its supply is called Par Rate of Exchange, Normal Rate or Equilibrium Rate of Foreign exchange.
- 11. Merits of Flexible Exchange Rate System (i) This system is not to be supported with international reserves of gold. (ii) It solves the problem of overvaluation or undervaluation of currencies. (iii) It promotes venture capital in the foreign exchange market. Trading in international currencies itself become an important economic activity. (iv) Promotes movement of capital across different parts of the world.
- 12. Demerits of Flexible Exchange Rate System (i) There is no stability. Flexible exchange rate keep fluctuating according to demand and supply. (ii) Instability in the foreign exchange market cause instability in the area of international trade. (iii) Coordination of macroeconomic policies become inconvenient due to day to day fluctuation in exchange rate.
- 13. • Fixed exchange rate is fixed in terms of gold, or any other currency by the government, whereas, flexible exchange rate is determined by the market forces of demand and supply of foreign currency. • Fixed exchange rate does not change with changes in demand and supply whereas flexible exchange rate changes with changes in demand and supply of foreign exchange rate.
- 14. • The theory of determination of rate of exchange is the demand and supply theory. • According to this theory, the rate of exchange of a country's currency is determined by the demand and supply of foreign exchange. R = f (D, S) where, R – Exchange Rate D – Demand of different currencies in the international market. S – Supply of different currencies in the international market. Determination of Flexible Exchange Rate System
- 15. Sources/Determinants of Demand for Foreign Currency • Payment in foreign exchange causes demand for foreign exchange. • Foreign exchange is demanded for the following reasons: (a) To purchase goods and services from foreign countries. (b) To purchase financial assets in foreign countries. (c) To send gifts and grants to abroad. (d) Remittances by foreigners working in India. (e) To undertake foreign tours. (f) To make payments of interest on loans and repay the international loans.
- 16. ▪ There is an inverse relationship between the price of foreign exchange and demand for foreign exchange. Exchange Rate ↑ - ↓ Demand Exchange Rate ↓ - ↑ Demand
- 17. • At OR rate of foreign exchange, OM quantity of foreign exchange is demanded. • It would be seen from above figure, a rise in the price of foreign exchange (OR – OR1) will result in a fall in the demand for foreign exchange (OM – OM1). • Similarly, if the price of foreign exchange falls, from (OR – OR2) more of the dollars would be demanded (OM - OM2).
- 18. Sources/Determinants of Supply of Foreign Currency • Supply of foreign exchange comes from foreigners who make us payments in foreign exchange for different purposes. • Following factors cause supply of foreign exchange: (a) Exports of goods and services to ROW. (b) Foreign tourists spend in foreign exchange in our country. (c) Foreign Direct Investment by Multinational Companies. (d) Direct purchase of shares and bonds by the foreign investors in India.
- 19. (e) Remittances by Indians working in abroad. (f) Deposits by NRI’s leads to flow of foreign exchange in the Indian foreign exchange market. • There is direct relationship between prices of foreign exchange and supply of foreign exchange. Exchange Rate ↑ - ↑ Supply of Foreign Exchange Exchange Rate ↓ - ↓ Supply of Foreign Exchange
- 20. • At OR rate of foreign exchange, OM quantity of foreign exchange is demanded. • A rise in the price of dollars from OR to OR2 results in more quantity of dollars being supplied, from OQ to OQ2. • Conversely, if the price of foreign exchange falls from OR to OR1, quantity supplied of dollars will fall from OQ to OQ1.
- 21. Determinantion of Equilibrium Rate of Foreign Exchange (Flexible) • Equilibrium exchange rate is determined at a point where the quantity demanded and the quantity supplied of foreign exchange are equal. • This can be demonstrated with the help of figure shown below, assuming foreign exchange is dollars.
- 22. Observations • Negatively sloped demand curve (DD) and positively sloped supply curve (SS) of foreign exchange intersect each other at point E. • Point E shows equilibrium between demand and supply of foreign exchange.
- 23. • Point E corresponds to equilibrium rate of foreign exchange which is OR. At this rate (OR), OM quantity of foreign exchange is demanded and supplied. • At a price higher than equilibrium price, say OR2, there will be excess supply (M1M2) of foreign exchange in India’s foreign markets. • This will push down the price (rate) of foreign exchange (Indian rupee will tend to appreciate). • It will cause extension in demand (Q to E) and contraction in supply (P to E) till it reaches the equilibrium position at OR.
- 24. • On the other hand, if the rate is lower than the equilibrium price say OR1, it will give rise to excess demand (M1M2) of foreign exchange. • This will pull up the rate of foreign exchange (Indian rupee will tend to depreciate). It will cause extension in supply (T to E) and contraction in demand (M to E) till it reaches the equilibrium position at OR.
- 25. Causes of Change in Rate of Foreign Exchange The foreign exchange rate may rise or fall depending changes in demand or supply of foreign exchange. In this section we will understand: (a) Currency Depreciation (When exchange rate rises) (b) Currency Appreciation (When exchange rate falls)
- 26. (A) Depreciation of Domestic Currency (Appreciation of Foreign Currency) • Depreciation of currency refers to decrease in the value of domestic currency in terms of foreign currency. • It occurs when there is an increase in the domestic currency price to buy a unit of foreign currency. For example – if price of one dollar ($) rises from Rs.50 to Rs.60. This is currency depreciation.
- 28. (i) Increase in demand for foreign exchange Observations • Due to increase in demand, DD curve shifts to right (DD – D1D1). • New equilibrium point E1 is achieved. • It shows rise in exchange rate from OR – OR1.
- 29. (ii) Decrease in supply of foreign currency Observations • Due to decrease in supply, SS curve shifts to left (SS – S1S1). • New equilibrium point E1 is achieved. • It shows rise in exchange rate from OR – OR1. • It shows depreciation of currency.
- 30. Effect of Depreciation of Domestic Currency on Foreign Trade (on Exports and Imports) (a) Effect of depreciation on exports: It encourages exports • Deprecation of domestic currency means a fall in the value of the domestic currency in terms of foreign currency. • It implies with the same one dollar, more of goods can be purchased from India. • It means exports by USA have become cheaper. This will encourage the exports.
- 31. (b) Effect of depreciation on imports: It discourages Imports • Deprecation of domestic currency means a fall in the price of domestic currency in terms of foreign currency. • It implies that more of domestic currency is required to buy goods worth 1 US dollar. • It means imports from USA have become costlier. This will discourage the imports.
- 33. (B) Appreciation of Domestic Currency (Depreciation of Foreign Currency) • Appreciation of currency refers to increase in the value of domestic currency in terms of foreign currency. • It occurs when there is a decrease in the domestic currency price to buy a unit of foreign currency. For example – if price of one dollar ($) falls from Rs.60 to Rs.50. This is currency appreciation.
- 35. (i) Fall in demand for foreign currency Observations • Due to decrease in demand, DD curve shifts to left (DD – D2D2). • New equilibrium point E2 is achieved. • It shows fall in exchange rate from OR to OR2. • It implies appreciation of currency.
- 36. (ii) Rise in supply of foreign currency Observations • Due to increase in supply, SS curve shifts to right (SS – S2S2). • New equilibrium point E2 is achieved. • It shows fall in exchange rate from OR to OR2. • It implies appreciation of currency.
- 37. Effect of Appreciation of Domestic Currency on Foreign Trade (on Exports and Imports) (a) Effect of appreciation on exports: It discourages exports • Appreciation of domestic currency means an increase in the value of the domestic currency in terms of foreign currency. • It implies that with same one dollar, less goods can be purchased from India. • It will discourage exports by USA, therefore exports to USA will decrease.
- 38. (b) Effect of appreciation on imports: It encourages imports • Appreciation of domestic currency means an increase in the value of the domestic currency in terms of foreign currency. • It implies that for same one dollar, less units of domestic currency are required. • It encourage imports from USA, therefore imports from USA will increase.
- 41. Devaluation and Revaluation of Domestic Currency • When a country brings down the value of its currency in terms of foreign currency by a government order, it is called devaluation of domestic currency. The effect of devaluation is the same as that of depreciation of the currency. • When country raises the value of its currency in terms of foreign currency by a government order, it is called revaluation of domestic currency. The effect of revaluation is the same as that of appreciation of currency.
- 42. Difference between Depreciation and Devaluation of Domestic Currency Basis Depreciation of Domestic Currency Devaluation of Domestic Currency 1. Meaning 2. Operation 3. System Decrease in the value of domestic currency in terms of foreign currency by market demand and supply. Takes place due to market force of demand and supply of foreign exchange. Flexible exchange rate system. Fall in the value of domestic currency by the Govt. Takes place due to the Govt. Order to correct BOP situation. Fixed exchange rate system.
- 43. Difference between Appreciation and Revaluation of Domestic Currency Basis Appreciation of Domestic Currency Revaluation of Domestic Currency 1. Meaning 2. Operation 3. System Increase in the value of domestic currency in terms of foreign currency by market demand and supply. Takes place due to market force of demand and supply of foreign exchange. Flexible exchange rate system. Rise in the value of domestic currency by the Govt. Takes place due to the Govt. Order to correct BOP situation. Fixed exchange rate system.
- 44. Managed Floating • It is a system in which the central bank allows the exchange rate to be determined by market forces but interferes at times to influence the exchange rate in case of depreciation or appreciation of domestic currency. • Managed floating is a tool employed by the central bank to restore the value of the country’s currency within the desired limits, even when the exchange rate is determined by the market forces of demand and supply.
- 45. • Central bank does not have full power but some power to manage exchange rate slightly according to the economy. • It is a system which allows adjustments in exchange rate according to a set of rules and regulations which are officially declared in foreign exchange market. • This system is a combination of fixed and flexible exchange rate. Therefore, it is also called a ‘hybrid system’. • If a country manipulates the exchange rate by not following rules and regulations, it is called dirty floating.
- 46. • During depreciation of domestic currency, the central bank starts selling the US dollars in the international market to restore the value of domestic currency. • During appreciation of domestic currency, the central bank starts buying the US dollars in the international market to restore the value of domestic currency. Depreciation - Sale of Foreign Currency Appreciation - Purchase of Foreign Currency
- 48. An Extra Mile I. Foreign Exchange Market • Foreign exchange market refers to the market for national currencies of different countries in the world. • It includes banks, specialized foreign exchange dealers brokers and official govt. agencies through which currency of one country can be exchanged for that of another country.
- 49. (A) Spot market • It refers to a market where current transactions in foreign exchange take place. • The market in which the receipts and payments of foreign exchange are made immediately is called spot market. • It is of daily nature. • The exchange rate which exists in spot market is called spot exchange rate.
- 50. (B) Forward Market • The market in which foreign exchange is bought and sold on a specified future date at a rate agreed upon today is called forward market. • The exchange rate that exists in forward market is known as forward rate. • Most of the international transactions occur on forward exchange rate. • The price at which the foreign exchange will be sold/ purchased is decided in advance on ‘SPOT’.
- 51. A forward contract is entered into for two reasons: ▪ One is to minimize risk of loss due to adverse change in exchange rate and second to make a profit. ▪ First is called hedging and the second is called speculation.
- 52. Presented by – Ritvik Tolumbia CS, CWA, M.Com (ABST), M.A (Eco), B.Ed Author & Faculty of Commerce