a /~\___ Learning Objectives “Meaning of foreign exchange and foreign exchange rate | Types of foreign exchange rates | X fined exchange rate system » flexible exchange rate system % managed floating rate system Determination of fiexible exchange rate sources/determinants of demand for foreign exchange % sources/determinants of supply of foreign exchange ® equilibrium rate of foreign exchange (flexible) % Causes of change in rate of foreign exchange % depreciation of currency + appreciation of currency | 1 reasons/causes of rise in demand for foreign currency | % reasons/causes of rise in supply for forelgn currency Meaning and functions of foreign exchange market | CHW A PEER Operation of foreign exchange market 2 spot market = forward market FOREIGN EXCHANGE RATE Th a modem 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, e.g., Rupee in India, Dollar in America, Yen in Japan etc., 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. The rate at which currency of one country is converted into currency of the other country, is called foreign rate of exchange or foreign exchange rate. 327328 UNIT V:: BALANCE OF PAYMENTS 11.1 MEANING OF FOREIGN EXCHANGE AND FOREIGN EXCHANGE RATE Foreign Exchange It refers to the sum total of the stocks of : (a) Foreign currencies. : (6) Securities and bonds issued by foreign corporates and government. Foreign Exchange Rate Itis the price of one currency in terms of another. It can be defined in two alternative ways; 1. It means the number of units of domestic currency required to buy a unit of foreign, currency, ¢.g., $1 = 850 (Exchange rate between India and America). 2. It means the number of units of foreign currency that can be purchased in exchange for a unit of domestic currency. For example, @1 = + $ e 50 The rate at which currency of one country is converted into currency of the other country, is called foreign rate of exchange or foreign exchange rate. It represents the external purchasing of a currency. Itis the rate at which exports and imports of a nation are valued at a given point of time. TL.2 TYPES OF FOREIGN EXCHANGE RATE SYSTEM ‘There are three types of foreign exchange rate system : [ Tynes of roreign exchange Rate System | ——_+ Fixed exchange Flexible exchange J “ea | ratesystem | rate system, rate system 11.2.1 Fixed Exchange Rate System Fixed exchange rate system refers to the system in which the rate of exchange for a currency is fixed by the government. Under this system, government is responsible to stabilise the exchange rate. Under fixed exchange rate system, each country maintains value of its currency fixed in terms of gold, silver, other precious metal, another country’s currency ete. There were two systems of Fixed Exchange Rate : > Gold standard system of exchange rate. > The Bretton Woods system. 1. Gold standard system of exchange rate (1870-1914) 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. Introductory MACROECONOMICS-Xll~ Chapter 11 : FOREIGN EXCHANGE RATE 329 For example, if 1£ (UK, pound) =2 g of gold and 18 (U.S. Dollar) then exchange rate would be 1 U.K, £ of gold uss ine aretton Woods system (1945-1971) This ystem was adopted to have transparency in the system. Under this system, all currencies were pegged or related to U.S. dollar which ultimately was convertible into gold. IMF (International Monetary Fund) worked as central institution in controlling the system. pox 1 Mert offsed exchange rate : 1, Itensures stability in exchange rate 2, Coordination of macro policies becomes convenient. 3, It prevents speculation in foreign exchange market. Demerits of fixed exchange rate : 1, It does not encourage venture capital. 2, There is possibility of under or over valuation of the currency. 3, Government has to maintain 100% gold reserves. 11.2.2 Flexible Exchange Rate System > It refers to a system in which exchange rate between currencies of different countries is determined by the market forces of demand and supply. > There is no government intervention in the foreign exchange market. > Exchange rate is determined by the 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. » Itis called flexible because it tends to change with changes in market forces of demand and supply. Merits of flexible exchange rate system : 1, It solves the problem of overvaluation or undervaluation of currencies. 2. There is no requirement of government to hold 100% gold reserves. 3. It encourages venture capital. Demerits of flexible exchange rate system : 1. There is no stability. Flexible exchange rate keeps fluctuating according to demand and supply. 2. This discourages international trade and coordination of macro policies becomes inconvenient. 1.2.3 Managed Floating Rate System > Itrefers to a system in which foreign exchange rate is central bank stabilizes the exchange rate in case of domestic currency. determined by market forces and appreciation or depreciation of Introductory MACROECONOMICS-XIl330 unr f foreign exchange t, buyer or seller o} 0 > The central bank intervenes as a bulk a uae in the exchange rate. When the exchange rate is high, ental bank BALANCE OF PAYMENTS os" Contra Starts to bring it down and vice ver selling foreign exchange (from its for-ex reserves) to» iB te done to protect the interest of importers and exporters. > Itis a system of adjustments in the exchan currency, > Itis also called a ‘hybrid’ system between fixed rate and flexible exchange rate, » Ifa country manipulates the exchange rate by not following rules and regulations, itis calleg dirty floating. > How rate, wever, Difference between Fixed and Flexible Exchange Rate ge rate fo Hnfluence the value of a coun, central banks follow a set of rules and regulations to influence the exchange Basis Fixed Exchange Rate Flexible Exchange Rate Meaning Fixed exchange rate is fixed in terms of gold | Flexible exchange rate is determined by the SF any other currency by the government, | market forces of demand and supply nf foreign currency. Effect of Fixed exchange rate does not change with | Flexible exchange rate changes with changes ‘market forces | changes in demand and supply of foreign | in demand and supply of foreign exchange exchange in the market, in the market. qaurol of | | There is full government control in deter- | There is no government intervention in Sovernment | mining the exchange rate. determining the exchange rate. Stability [Axed exchange rate generally remains stable, | Flexible exchange rate changes whenever Any variation is initiated by the there is change in market forces of demand government. and supply. 113 DETERMINATION OF FLEXIBLE EXCHANGE RATE Flexible rate of exchange is the rate which is determined by the demand for and supply of the currencies in the foreign exchange market. R= f(D,8) where, R= Exchange rate ; D= Demand of foreign currencies ; S= Supply of foreign currencies 11.3.1 Sources/Determinants of Demand for Foreign Exchange The demand of foreign exchange arises in order to make Payment in foreign currency. It is demanded by domestic residents for the following reason 1. Import of Goods and Services. When India imports some goods and services from rest of the world, it has to make the payment in foreign exchange. There would be a demand for foreign exchange in India’s foreign exchange market 2. Tourism. Tourists require foreign exchange to meet their expenditure abroad. They will Introductory MACROECONOMICS--xilsaaton between Price of Foreign Exchange and Demand Chopter 11 : FOREIGN EXCHANGE RATE 331] smittances by Forei foe Se ad Te di back 4 Pentdia. These foreign workers eam their income purpose. ‘omeland. They demand foreign exchange for this 4, Repayment of Interest and Loans, loans to foreign lenders, ans. We have " to pay interest on loan: a 80 We require foreign exchange. 5, Extension of Loans to Foreigners, f i coi, Indi wil deme em, ae to extend assistance to other In short, any transaction that re foreign exchange ‘quites a payment in foreign exchange, forei ; 's and repay the Tesults in demand for (Refer to section 11.5.1 for “Reasons for Rise/Fall in demand of Foreign currency”,) : for Foreign Exchange ‘There is an inverse relationship betwe, , , en the price of foreign exchange and the demand for foreign exchange, ie, at a higher price, less of the foreign exchangeis demanded and vice-versa, ‘The relationship between the price of foreign exchange and the quantity demanded of foreign exchange can be illustrated graphically ; with the help of a downward sloping curve as shown in Fig. 11.1. At OR rate of foreign exchange, OM quantity of foreign exchange is demanded. It would be a seen from Fig. 11.1, a rise in the price of foreign 7 exchange from OR to OR : 1 (ie., a depreciation of the Indian currency) will result in a fall in the demand for foreign exchange (OM—OM,) Similarly, if the price of foreign exchange falls, Rupees Price of Dollar No from OR to OR, (i.e,, Indian rupee appreciates ' ' in value) more of the dollars would be $ ca a x demanded (OM,). In other words, more of the tM: ‘ Quantity of US Dollars foreign goods and services would be demanded. Figure 11.1 11.3.2, Sources/Determinants of Supply for Foreign Exchange Any transaction that involves receipts of foreign exchange leads to an increase in the supply of foreign exchange. The major sources of supply of foreign exchange can be recognised as follows : 1. Export of Goods and Services. Whenever the foreigners purchase our goods and services, we are paid in foreign exchange. The supply of foreign exchange in India's foreign exchange market increases. Foreign Tourists in India. Foreign tourists spend in foreign exchange in our country. The supply of foreign exchange increases in our country. Remittances by Indians Working abroad. Indian workers who have gone abroad send their savings to their homeland in India. The supply of foreign exchange in India's foreign exchange market increases. Introductory MACROECONOMICS-XIl332 Relation between the Price of Foreign Exchange and Supply of Foreign Exchange UNIT V : BALANCE OF PAYMENTS a ies. Investment by MNC’. 4. Foreign Direct Investment by Multinational Companies. eo flow of foreign exchange in In 5. Purchase of Shares (Portfolio Investment) Indian stock exchange by foreign investors re Indian share markets. : : 6. Deposits by Non-resident Indians. Due to deposits by NRIs’, foreign exchange flows, the Indian foreign exchange market. Stesuty, by Foreign Investors. Any purch, ase sults in flow of foreign exchange tg {0 the (Refer to section 11:5.2 for “Reasons for Rise or Fall in supply of foreign currency.) The supply of foreign exchange has a direct relationship with the price of foreign exchange » If the price of foreign exchange goes up, the quantity supplied of foreign exchange wil} also rise. » If the price of foreign exchange falls, the quantity supplied of foreign exchange will also fall. The direct relationship between the price of foreign exchange and the quantity supplied of y foreign exchange can be shown graphically with the help of an upward sloping curve as shown 1 in the Fig. 11.2. 32 It is clear from the figure that quantity supplied 3 = of dollars bears a direct relationship with the £ E price. s A rise in the price of dollars from OR to OR, results in more quantity of dollars being ° a2 2 2 supplied, from OQ to OQ,. Quantity of Dollars Conversely, if the price of foreign exchange falls from OR to OR;, quantity supplied of dollars Figure 11.2 will fall from OQ to OQ,. 11.3.3 Determinants of Equilibrium Rate of Foreign Exchange (Flexible) Equilibrium rate of exchange is established 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. Observations 1. Negatively sloped demand curve (DD) and po: sitively sloped supply curve (SS) of foreign exchange intersect each other at point E. 2. Point E shows equilibrium between demand and supply of foreign exchange. 3. Point E corresponds to equilibrium rate of exchange which is OR 4. At this price (OR), OM quantity of foreign exchange is demanded and supplied. Thus, in Fig. 11.3, OR is the price at which the quantity demanded and the quantity supplied of dollars are equal (OM). Introductory MACROECONOMICS-XILChopler 11 : FOREIGN EXCHANGE RATE 333 ‘Ata price higher than equilibri foreign exchange in India’s foreign markets one exchange (Indian rupee will tend to appreciate) contraction in supply (P to E) kil it reaches ie On the other hand, if the rate is lower than the equilibrium price say OR,, it will give tise to vf excess demand (M,M,) 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. The rate of exchange will tend to move towards the equilibrium level. At the level of equilibrium, the quantity demanded and quantity supplied of Aare aaa Aleta foreign exchange will always be equal, oe Price, say OR,, there will be excess supply (M,M,) of will push down the price (rate) of foreign Ttwill cause extension in demand (Qto E) and equilibrium position at OR Excess g Rate of Foreign Exchange Figure 11.3 State whether the following statements are true or false 1. Foreign exchange rate is determined by market forces of demand and supply for foreign exchange. 2. A person willing to purchase a house in America demands U‘S. dollars to make this purchase. 3, Increase in imports from a domestic country causes inflow of foreign exchange. 4. There is negative relation between foreign exchange rate and demand for foreign exchange. 5. We do not demand foreign exchange for making unilateral transfers abroad. Answers 1 True 2 True 3. False 4. True 5. False 1L4 CAUSES OF CHANGE IN RATE OF FOREIGN EXCHANGE The foreign exchange rate may rise or fall depending upon changes in demand or supply of foreign exchange. In this section we will understand : > Currency Deprecation (When Exchange Rate Rises) > Currency Appreciation (When Exchange Rate Falls) 11.4.1 Depreciation of Domestic Currency (Appreciation of Foreign Currency) Depreciation of currency refers to decrease in the value (external purchasing power) of domestic currency in terms of foreign currency. It occurs when there is an increase in the domestic Currency price (exchange rate) to buy a unit of foreign currency eg, if price of one dollar ($) rises from %60 to 270, This is currency depreciation for domestic country. > A rise in exchange rate implies depreciation of Indian rupee. > Causes for rise in exchange rate are : (@ Increase in demand for foreign exchange Or (i) Decrease in supply of foreign exchange Introductory MACROECONOMICS-Xil334 UNIT V : BALANCE OF PAYMENTS Let us understand with the help of diagrams + (i) Increase in demand for foreign exchange Exchange Rate % pers) = o M My (Quantity of Foreign Exchange Figure 11.4 Observations (OR = Exchange rate ] NOTE Chain of effects may be given if asked. Refer (0 Box 11.2 for detail. 1. Due to increase in demand, DD curve shifts to right (DD—D,D,). 2. New equilibrium point E, is achieved. 3. It shows rise in exchange rate from OR to OR,. 4. It shows depreciation of domestic currency. Chainiofi Effects inicase of Increase: Demand of Foreign Exchange: Observations (Due to increase in demand of foreign exchange, the demand curve shifts to right from. DD to DD. (i) This causes excess demand EN. (iii) Due to excess demand, there is competition among buyers, Exchange Rate which pushes the price upwards. (i) Due to increase in price, supply extends from point E to point E, and demand contracts from point N to point E, (®) Market demand and market supply of foreign exchange become equal again at point E, which corresponds to a higher foreign exchange rate OR, and higher equilibrium quantity OM,. Introductory MACROECONOMICS-XII Figure 11.5 x Quantity of foreign exchangeChopler 11 : FOREIGN EXCHANGE RATE 335 fi pecrease in supply of foreign exchange i yA OR = Exchange rate = Equilibrium point OM = Equilibrium quanti = Exchange Rate @ per 8) > Cem x NOTE Quantity of Foreign Exchange Chain of effects may be given if asked, Refer to Box 11.3 for Figure 11.6 a Observations 1. Due to —. in supply, the supply curve shifts to left (SS—S,S,). 2. New equilibrium point E, is achieved. 3, It shows rise in exchange rate from OR to OR. 4, It shows depreciation of domestic currency. Observations ( Due to fall in supply of foreign exchange, the supply curve shifts to left from SS to §5,. 4) (ii) This causes excess demand TE. zB (ii) This causes competition among buyers which pushes the prices upwards. Exchange rate > (i) Due to rise in price, the demand contracts from point E to point F, and supply extends from point T to point &,. ol (x) Market demand and market supply of foreign ‘Quantity of exchange become equal again at point E which foreign exchange corresponds to a higher foreign exchange rate OR, and lower equilibrium quantity OM, Figuie 11.7 (Refer to Q. 3(a) of HOTS for difference between Devaluation and Depreciation of currency.) Introductory MACROECONOMICS-XIl| 336 Unit v: BALANCE OF PAYMENTS ‘fect of Depreciation of Domestic Currency on Foreign Trade (on Exports and Imports) (A) Effect of depreciation on exports : It encourages exports - > Depreciation of domestic currency means a fall in the value of the domestic currenc, tn terms of foreign currency. For example, if price of 1 rises from %60 to 870, 5 | > It means that one dollar can be exchanged for more rupees. > It implies that with same one dollar, more goods can be purchased from India, > Temeans that imports by USA will increase or depreciation of currency will encourage exports (8) Effect of depreciation on imports : It discourages imports > Depreciation means a fal in the value of the domestic currency in terms of foreign currency, For example, if Price of 1$ rises from %60 to 70. » It means that 1 dollar will be exchanged for more rupees. > Itimplies that more of domestic currency is required to buy goods worth 1 dollar. * Tr means that imports from USA have become costlier, therefore imports will decrease gy depreciation of currency will discourage imports. ‘Devaluation and Depreciation of currency are one and the same thing’. Do you agree ? How do they affect the exports of a country ? (CBSE SP 15-16 ; SP 17-19 Ans. No, the two are not same Devaluation isthe fallin the value of domestic currency in relation to foreign currency as planned by the government. It is not determined by the forces of demand and supply, it is fixed by the government of different countries. Whereas Depreciation isthe fallin the value of domestic currency in relation to foreign currency ina Situation when exchange rate is determined by the forces of demand and supply in the internatfonal money market. In both the situations (depreciation and devaluation) exports of goods and services increase as the other countries are able to buy more goods from the domestic country, hence exports are encouraged 2. According to recent media reports : ‘USA has accused China of currency devaluation to promote its exports’. In the light of the given media report comment, how exports can be promoted through the currency devaluation ? (CBSE SP 2018) Ans, USA has a valid point of argument as devaluation of a currency encourages exports ofa country. As exported goods become cheaper in the international market giving a competitive edge for the Boods of domestic country (China). Devaluation of the value of domestic currency promotes the exports of the country and may adversely impact the production and sale of importing, country. 11.4.2 Appreciation of Domestic Currency (Depreciation of Foreign Currency) Appreciation of currency refers to increase in the value (external purchasing power) of domestic currency in terms of foreign currency. It occurs when there is a decrease in the domestic currency price (exchange rate) to buy a unit of foreign currency eg, if 1 dollar is Introductory MACROECONOMICS-XilChopter 11 : FOREIGN EXCHANGE RATE 337 exchanged for %60 and now the exchan, ee '8¢ Tate falls to 850 for one dollar. This is appreciation of > A fall in exchange rate implies appreciat; PPreciation i » Causes for decrease in exchange rate are Sk) @ Fall in demand of foreign currency ii) Rise in supply of foreign currency {pall in demand of foreign currency i OR = Exchange rate E= Equilibrium point OM = Equilibrium quantity Exchange Rate @ per $) & q oo. ’ NOTE aD Chain of effects may be given if asked. Refer Box 11.5 for detail. Figure 11.8 Observations 1. Due to decrease in demand, DD curve shifts to left (DD—D,D,). 2. New equilibrium point E, is achieved. 3. It shows fall in exchange rate from OR to OR,. 4, It implies appreciation of domestic currency. Cefrretta es? Ages Hal oR Che UBKeta Ce Demand)ofiForeigniExchange: Observations () Due to decrease in demand of foreign exchange, . the demand curve shifts to left from DD to D,D,. (ii) This causes excess supply TE. 2 (iii) This leads to competition among sellers which s pulls the price downwards. 4 (i) Due to decrease in price, supply contracts from a point Eto point E, and demand extends from point a T to point E,. : (2) Market demand and market supply of foreign ° Mz M__ Quantity of exchange become equal again at point £, which foreign exchange corresponds to a lower foreign exchange rate OR, and a lower equilibrium quantity OM,. Figure 11.9 Introductory MACROECONOMICS-XIl338 UNIT V : BALANCE OF PAYMENTS (ii) Rise in supply of foreign currency vA S OR= Exchange rate , E= Equilibrium point , OM = Equilibrium quantity Exchange Rate per $) 2 Observations x | ° M M, NOTE Quantity of Chain of effects may be given if asked. Refer Foreign Exchange to t0 Box 11.6 for detail. Figure 11.10 Due to increase in supply, the supply curve shifts to right (SS—S,S,). New equilibrium point E, is achieved. It shows fall in exchange rate from OR to OR,. eye It implies appreciation of domestic currency. Chainjof/Effects\in)caselofiincrease’ intSUpplylofikoreigniExchange: Observations (Due to rise in supply of foreign exchange, the supply curve shifts to right from SS to 5,5, (i) This causes excess supply EN. (ii) Due to increase in supply, there is more competition among sellers which pulls the price downwards. Exchange rate (iv) Due to fallin price, the demand extends from point E to point E, and supply contracts from point N to point E,. Quantity of (®) Market demand and market supply of foreign foreign exchange exchange become equal again at point E which I corresponds to a lower foreign exchange rate OR, Figure 11.11 | and a higher equilibrium quantity OM,. (Refer to Q. 3(H) of HOTS for difference between Revaluation and Appreciation of currency.)ye Chopler 1]: FOREIGN EXCHANGE RATE 339. fet of Appreciation of Domestic Currency on Foreign Trade (on exports and imports) (A) Effect of appreciation of domestic currency on exports. : It discourages exports Appreciation of domesti > Appreciat lomestic currency means an increase in the value of the domesti currency in terms of foreign currency. _— For example, if price of 1$ falls from 260 to 50. > It means that one $ can be exchanged for less rupees > It implies that with same one dollar, less goods can be purchased from India. » It will discourage imports by USA, therefore exports to USA will decrease (8) Effect of appreciation of domestic currency on imports : It encourages imports > Appreciation of domestic currency means an increase in the value of the domestic currency in terms of foreign currency. For example, if price of 1$ falls from %60 to 750. > It means that 1 dollar will be exchanged for less rupees. > Itimplies that for same one dollar, less units of domestic currency are required. > It will encourage imports from USA, therefore imports from USA will increase 11.5 CAUSES/REASONS FOR RISE/FALL IN DEMAND AND SUPPLY OF FOREIGN CURRENCY 11.5.1 Reasons/Causes of Rise in Demand for Foreign Currency (when price of foreign currency falls, its demand rises) ‘The demand for foreign currency rises because of appreciation of domestic currency (Fall in price of foreign currency). Appreciation of domestic currency means an increase in the value (external purchasing, power) of the domestic currency in terms of foreign currency. For example, if price of 1 § falls from %60 to €50, it means that one dollar will be exchanged for lesser rupees. Therefore, demand of foreign currency rises because + » When price of foreign currency falls, its demand rises for speculative purpose as now it is available at low price. y It makes imports cheaper as the domestic country has to pay lesser price now. > Tourism to the foreign country increases as travelling abroad has now become relatively cheaper. > Fall in exchange rate would increase the level of investment abroad. [ (When price of a foreign currency rises, its demand falls, why ? Hint. Depreciation of domestic currency.) 11.5.2 Reasons/Causes of Rise in Supply of Foreign Currency (when price of foreign currency rises, its supply rises) ; The supply of foreign currency rises because of depreciation of domestic currency (rise in price of a foreign currency). Depreciation ‘of domestic currency means a fall in the value (external purchasing power) of the domestic currency in terms of foreign currency. For example, if price of 1 § rises from %60 to 870, it means that one dollar can be exchanged for more rupees. Introductory MACROECONOMICS340 unr BALANCE OF PAYMENTS Therefore, supply of foreign currency rises because : ~ When price of foreign currency rises, it encourages exports as with same UN OF forg, currency, more goods can be purchased from domestic country. ign ~ Supply of foreign exchange rises due to increasing tendency towards making Specuaig Bains in the domestic country. ~ When price of foreign Sumency rises, investment from the foreign SOUNEEY int thy domestic country rises as Purchasing power of foreign currency in the domestic country rises, * Tourism into the domestic country rises as travelling to the domestic country become relatively cheaper. > Appreciation of foreign currency increases direct purchases by the non-resident domestic country, I Old exchange rate New exchange rate Appreciating currency | Depreciation currency L 1-92 1£=93 || 18 = 100¥ 18 = 105y 3. %50=15 %65 = 15 } 4. 140 = 4€ 120 = 4e 5. 1€=%60 1€ = %0 | Answers } Old exchange rate New exchange rate Appreciating currency | Depreciation currency 1 1€=$2 1£=$3 £ $ 2 1$ = 100¥ 1$ = 105¥ $s ¥ 3. %50=1$ %65 = 15 $ - | 4. 7140 = 4€ 7120 = 4e zg £ | 5. 1€=%60 1€ = %80 - z 11.6 MEANING OF FOREIGN EXCHANGE MARKET It is defined as the market in which foreign currencies are bought and sold. It isa system where buyers and sellers of foreign currency provide facilities trading of foreign currencies. Foreign exchange market constitutes brokers, banks, central bent etc. “It is the market where national currencies are traded for one another” Introductory MACROECONOMICS-¥iIlChapler 11 : FOREIGN EXCHANGE RATE 161 Functions of Foreign Exchange Market 1. Transfer Function. It arises when 7 : some tr: i takes place. It implies transfer of ee een residents of two countries r purchasin; i ae eee iB Power in terms of foreign exchange across 2. Credit Function. Like domestic trade, forei ; s » foreign trade also depends on credi i exchange market provides for credit in Foreign trade transactions (for epee ia ee goods and services). ae 341 3. Hedging Function. It implies protection against the risk concerning, variations in foreign exchange rate. Demand and supply of foreign exchange is committed at some commonly agreed rate of exchange even when the commitments are joured on soi / to be hon ; me Box 11.7 ARES Eine iinsien os boss dneneisnieues| ‘The hedging function : Suppose, you own a tea producing unit. You have placed an order to an American manufacturer for a new machine that costs $1 million. Order had been placed on 01.01.2016. The expected date of delivery is 01.09.2016. On delivery, a payment of $1 million is contracted to be made. On 01.01.2016, the exchange rate between the $ and @ is $1 =%45.00. Therefore, you are required to pay 45 million on 01.09.2016. Suppose on 01.09.2016, the rate of exchange turns out to be $1 =%46 , Now, you would have to give out %46 million to pay $1 million. ‘You would have to suffer a loss of 21 million. You can ‘hedge’ yourself against this foreign exchange risk. This is, where foreign exchange market can protect the buyers. You can purchase $1 million today on spot for forward delivery on 01.09.2016. What it means is that you enter into a contract to purchase $1 million on 01.09.2016 at $1 = 45, the rate which prevailed on 01.01.2016. Now, whatever the rate on 01.09.2016, you will have to purchase at $1 =€45.00, the rate might change to $1 =%40.00, or $1 =%46,00. You have hedged yourself against the exchange rate risk. The exchange rate risk is now being carried by the exchange dealer. The exchange dealer would have to be compensated for in the form of commission for his services. He will have to be paid some ‘premium’ over and above the current spot rate or discount if the rate is expected to fall in future. 1.7 OPERATION OF FOREIGN EXCHANGE MARKET There are two types of markets for foreign exchange. These are classified as Spot market and Forward market on the basis of the time period of transaction undertaken. They are explained as under : 11.7.1. Spot Market Itrefers to a market where current transactions in foreign exchange take place. The sale and purchase of foreign currency is affected at the prevailing rate of exchange on #he SP0L TA delivery of foreign exchange is also affected instantaneously. The rate at which cw transactions take place is called Spot Rate. For example, you receive a gift of $100 from your uncle. Your account is credited with 6000 at the current rate of exchange if $1 = %60. Introductory MACROECONOMICS342 unry BALANCE OF PAYMENTS 11.7.2 Forward Market In a forward transaction in foreign exchange market, (@) contracts to purchase and sell foreign exchange are entered on ‘SPOT’. (0) the price at which the foreign exchange will be sold/purchased is decided in advance on ‘SPOT’. NOTE o cified date in 0 Payment will be made on the specifi A forward contract i entered into for two reasons : One is 0 minimise risk of loss due to adverse change in exchange rate or to make a profit, First is called hedging and the second is called speculation, (@) the forward seller may charge a premium or offer a ‘discount’ on the spot rate, (©) the rate at which forward transactions (future delivery of foreign exchange) take place is called Forward Rate, Cestion Bank MULTIPLE CHOICE QUESTIONS 1. Foreign exchange is a stock of (4) foreign currencies (©) securities issued by foreign corporates (@) bonds issued by foreign corporates (@) allof these. 2 When foreign exchange rate rises, the demand of foreign exchange (@ rises © falls (©) does not change (@) none of these. 3+ ecrease in the value of domestic currency in terms of foreign currency is (@) appreciation of domestic currency (©) revaluation of domestic currency (©) depreciation of domestic currency (@ none of these. 4. Appreciation of domestic currency encourages (@ imports (© exports (© foreign trade (@) all of these. 5. Foreign exchange market constitutes (@) central bank () brokers (©) commercial banks (A) all of these. 6. Foreign exchange rate is determined by : (@) demand for foreign exchange (©) supply of foreign exchange (©) both (a) and (b) (@ neither (@) nor (6), 7 Other things remaining unchanged, when in a country the price of domestic currency rises, national income i (CBSE D 15) (@) likely to rise © likely to fall (© likely to rise and fall both (@ not affected 8. Other things remaining the same, when in a country the market price of foreign currency falls, national income is likely : (CBSE OD 15) (@ to rise (©) 10 fall (9 tise or to fall (@) to remain unaffected Introductory MACROECONOMICS-xi|Chapter 11: FOREIGN EXCHANGE RATE 343 g, Other things remaining the same, a ae when foreign currency becomes cheaper, the effect on national income (@ Positive on (CBSE F 15) ative (© Positive and negative both (No effect 49, Flexible exchange rate system is also known as (@) Managed floating system (6) Pegged exchange rate system (©) Floating exchange rate system (@) None of these. Answers 1 @ 2 3. (0) 4. (@) 5. @) 6 7. (a) 8. (b) 9. (b) 10. (c) OBJECTIVE TYPE QUESTIONS 1. What is foreign exchange ? Es Foreign exchange means foreign currencies. For example, Dollars, Yen, Pound are foreign exchange for India. 2, What determines the rate of foreign exchange ? ‘Ans. The rate of foreign exchange is determined by forces of demand and supply of foreign exchange 3, How is foreign exchange rate determined ? ‘Ans. The rate of foreign exchange is determined at a point where demand for and supply of foreign exchange are equal. 4, Define foreign exchange market. ‘Ans. The market in which currencies of various countries are converted or exchanged for one another is called foreign exchange market. 5. What is the nature of (i) Relation between price and demand of foreign exchange (ii) Relation between price and supply of foreign exchange ? ‘Ans, There is inverse relationship between rate of foreign exchange and demand for foreign exchange. ‘There is positive relationship between rate of foreign exchange and supply of foreign exchange. 6. What is the major reason for rise in demand for foreign currency when its price falls ? ‘Ans, When price of foreign exchange falls, imports from that country become cheaper ¢g., when exchange rate fall from 250 to 240 for one dollar, it means less rupees are required to buy goods worth 1 dollar from ‘America, hence demand rises. 7. What is the major reason for increase in supply of foreign currency when its price rises ? ‘Ans, When price of foreign exchange rises, exports are encouraged, as it makes Indian goods cheaper ‘> other countries eg, ifexchange rate rises from %50 to 860 for one dollar, it means America can buy more goods with one dollar, hence supply increases. 8. What is parity value ? ‘Ans.Ina fixed exchange rate system, the value of a currency would be fixed in terms of other currency OF in terms of gold. This value is known as parity value. CONCEPTUAL QUESTIONS 1. What is foreign exchange rate ? ‘Ans, Foreign exchange rate refers to the rate at which the currency of one country is exchanged with the currency of another country, for example, if £60 are to be paid to buy one US dollar, then the exchange rate between two currencies is $1 =%60 Introductory MACROECONOMICS-XIlfe 344 UNIT Vv: BALANCE OF PAYMENTS 2 Defin exchange rate . ve ai — rate is the rate which is fixed in terms of gold Ree Currency by the government. It remains fixed till it is changed by the government or inge rate ? 7 ae Cee ies the rate which is determined by the interaction of demand and suppty gy foreign exchange in the foreign exchange market. |. Define depreciation and appreciation of domestic currency. ‘ ‘ re pair of a aa there isa fallin the value of domestic currency in terms of foreign currency. ; : Appreciation of currency means there is a rise in the value of domestic currency in terms of foreign currency. 5. What are the causes for demand (outflow) of foreign exchange ? Ans. The causes are + Imports of goods and services ++ Repayment of loans + Unilateral transfers to abroad > Tourism etc. 6 What are the causes for supply (inflow) of, ‘foreign exchange ? Ans. The causes are : + Exports of goods and services + Foreign investments > Unilateral transfers from abroad Tourism etc, 7 What is the basic difference between the spot rate and fortoard rate ? Ans. The rate at which current transactions take place is called spot rate. Whereas the exchange rate that prevails in a future contract for Purchase and sale of foreign exchange is called forward rate. 8. What isthe basic difference between the spot market and forward market ? Ans. If the operation of market is of daily nature, it is called s1 operation of market is for future delivery of foreign ex 2 1 spot or current market whereas, if the ‘change, it is called forward market. gher Order Thinking Skills HOTS What is demand for foreign exchange for speculative activities ? Ans. Demand for foreign exchange for speculative activities is, value of foreign currency, speculators demand foreign exchang Prices to earn speculative gain, when people want to speculate on the © at present to sell it in future at higher 2. State whether the following items constitute demai (Indian going to USA for education. (ii) Import of goods from Japan. (iii) Foreign tourists in India, (iv) Bought 1500 US dollars for speculation, (®) Exports to England. Ans. Demand for foreign exchange : (i), (i), (i); Supply of foreign exchange : (ii), (v) ind or supply of foreign exchange. Introductory MACROECONOMICS-Xiyr pifferentiate between (a) Devaluation and Depreciation (b) Revaluation and Appreciation. ‘ans. (2) Difference between Devaluation and Depreciation of currency Chapter 11 : FOREIGN EXCHANGE RATE 345 Devaluation Depreciation Devaluation refers to reduction in value of | Depreciation refers to fall in value of domestic domestic currency in terms of a foreign currency | currency in terms of a foreign currency under lunder fixed exchange rate regime. flexible exchange rate regime. iris done in a fixed exchange rate system, Depreciation occurs in a flexible exchange rate system. Devaluation is done by government delibe- | Depreciation takes place under the influence of rately to correct BOP situation. changes in demand for and supply of a currency. (0) Difference between Revaluation and Appreciation of currency Revaluation Appreciation Revaluation refers to increase in value of | Appreciation refers to rise in value of domestic domestic currency in terms of a foreign currency | currency in terms of a foreign currency under under fixed exchange rate regime, flexible exchange rate regime. Revaluation is done in a fixed exchange rate | Appreciation occurs in a flexible exchange rate system. system. Revaluation is done by government delibe- | Appreciation takes place under the influence of rately to correct BOP situation changes in demand for and supply of a currency. 4. When does managed floating system become dirty floating ? ‘Ans. Under the system of managed floating, floating of exchange rate is managed by the monetary authority of the country by following some rules and regulations (Guidelines for the management of floating exchange rates). If the floating exchange rates are managed without observing any rules and regulations, it becomes dirty floating. VYiive Based Questions 1. (@) What is depreciation of domestic currency in terms of US dollar? Explain with a diagram. (©) How wil it afect your cost of education, if you are planning to go to USA for higher studies ? Ans. (a) Depreciation of domestic currency refer to decrease in the value of domestic currency in terms of foreign currency (here US dollar, Refer to section 11.4.1 for diagrams). (®) Depreciation of domestic currency for me would imply that there is an increase in the domestic currency price to buy one unit of US currency (US dollar) for example, if price of one dollar rises from 255 to 62, it will increase the cost of education in USA (implying more expenditure/burden on my parents). 2 Appreciation of Indian currency implies strengthening of Indian rupee. However exporters do not favour Appreciation of Indian currency. Why ? Ans. Appreciation of domestic currency means an increase in the value of the domestic currency in terms of foreign currency. Itimplies that one unit of foreign currency can be exchanged for less rupees for example if Price of 1 § falls from %55 to 50. Exporters do not favour this because it would discourage exports from India because with same one unit ‘reign currency, less goods can be purchased from India. Introductory MACROECONOMICS-XIL lz346 unit v; BALANCE OF PAYMENTS | of the imports of essential goo, 3. The market price of US dollar has incrensed considerably leading fo rise" prices of ie : What can central bank do to ease the situation ? . eee Ne ea to bale ae price of US dollar in terms: of Indian rupee, central bank can start selling US dollars from its reserves to increase the supply of US dollars Crteions to NCERT Questions 1. Would the central bank need to interve ranaged floating system ? Explain why. in i iged floating system ? intervene in a mi fl ‘Ans. In a managed floating system, foreign exchange rate is [by m rth central bank needs to interfere in this system in onder fo control fluctuations in ihe exchange ate shin certain limits. This is done in accordance with certain rules and regulations, so that manag ing does not become dirty floating, 2. Are the concepts of demand for domestic goods and domestic ‘Ans. No, the two concepts are not same. The demand for goods by both domestic country and foreign countries, On the other hand, d total of domestic demand for domestic goods and foreign goods. i 3. Ifinflation is higher in country A than in country B, and the exchange rate between the two countries is fixed, what is likely to happen to the trade balance between the two countries ? ‘Ans. The exports from country B to country A will rise and it will lead to surplus trade balance for country ! B. However, due to higher prices in country A, its imports will increase from country B and it will lead to ! deficit in trade balance for country A. It is due to fixed exchange rate. } 4. Differentiate between devaluation and depreciation, { 5. Distinguish between nominal exchange rate and real exchange rate. If you were to decide whether to buy domestic ‘goods or foreign goods, which rate would be more relevant ? Explain, ‘Ans. Nominal exchange rate is defined as price of foreign currency in terms of domestic currency whereas real exchange rate is defined as price of goods and services abroad in relation to those in domestic country (home country). Real exchange rate would be more appropriate as it measures price level. 6. How is the exchange rate determined under a flexible exchange rate regime ? [Refer to Section 11.3.3] demand for goods the same ? 1r domestic goods is the sum total of demand for jomestic demand is the sum IRefer to HOTS Q. 3(a)] VeRY SHORT ANSWER TYPE QUESTIONS (1 Mark) 1. What is meant by depreciation of domestic currency ? (CBSE AL17) | 2. What do yo mean by appreciation of currency ? 3. Define flexible exchange rate system. (CBSE D 08) 4. State two sources of supply of foreign currency. (CBSE Sample Paper 10) 5. What is meant by (flexible) foreign exchange rate ? (CBSE D 11 ; Sample Paper 10 ; F 14, OD 1 6. The price of one US dollar has fallen from 850 to 848, Has the Indian currency appreciated or depreciated? 7. What is the meaning of forward market ? Introductory MACROECONOMICS-XiI10. tt me Be we Be 16. 1 8. we. 0. a. St 1B. 4, 1. 16. v. Chapter 11 : FOREIGN EXCHANGE RATE 347 hat is meant by foreign exchange market ? what is meant By spot exchange rate ? | What is the meaning of forward exchange rate ? what do you mean by foreign exchange ? What are the two sources of demand for foreign exchange ? hat is meaning of managed floating exchange rate system ? hat are the effects of depreciation of foreign exchange on exports and imports ? Name the three functions of foreign exchange market. (case OD 1) ‘The market price of US dollar has increased considerably leading to rise in prices of the imports of essential goods. What can Central Bank do to ease the situation ? (cBse SP 12) How can RBI help in bringing down the foreign exchange rate which is very high? (CBSE OD 13) How can increase in foreign direct investment affect the price of foreign exchange ? (case D1) What is floating exchange rate ? (CBSE OD 14) What is devaluation ? (CBSE F14) Other things remaining the same, when in a country the market price of foreign currency falls, national income is likely : (a) torise (0) to fall (c) to rise or to fall (@) to remain unaffected (CBSE OD 2015) ORT ANSWER TYPE QUESTIONS (3/4 Marks) Explain the effect of depreciation of domestic currency on exports. (CBSE OD 13; SP 10, 12) Explain two sources each of demand and supply of foreign exchange. (CBSE Sample Paper 09) Explain the effect of appreciation of domestic currency on imports (CBSE SP 10, 12; D 13) What is meant by foreign exchange rate ? Why does a rise in foreign exchange rate cause a rise in supply? (CBSE SP 08) What is meant by foreign exchange rate? Give three reasons why people desire to have foreign exchange. Give two reasons for rise in demand for a foreign currency when its price falls. (CBSE SP 08) Why does the demand curve of foreign exchange slope downwards ? When price of a foreign currency falls, the demand for that foreign currency rises. Explain why. Or (CBSE OD 1) When price of a foreign currency falls, the supply of that foreign currency also falls. Explain why When price of a foreign currency rises, its demand falls. Explain why. (CBSE D 1) When price of a foreign currency rises, its supply also rises. Explain why. (CBSE D 11) |. How is exchange rate determined in the foreign exchange market ? Explain. (CBSE OD 13) ts and how ? Foreign exchange rate in India is on the rise recently. What impact is it likely to have on expo (CBSE OD 1) at impacts likely to have on imports and how ? (CBSE OD 19) (CBSE OD 14; F149) Foreign exchange rate in India is on the rise recently. Wh: Explain the effect of appreciation of domestic currency on exports. Recently government of India has doubled the import duty on gold. What impact is it likely to have on (CBSE D 14) Foreign exchange rate and how ? Visits of foreign countries for sight impact on foreign exchange rate and how ? How does giving incentives for exports influence foreign exchange rate ? Explain. seeing etc. by the people of India is on the rise, What will be its likely (CBSE D 14) (CBSE D 14) Introductory MACROECONOMICS-XI348 unit v.; BALANCE OF PAYMENTS ‘i id how ? (cose | 18. What is depreciation of Rupee ? What is its likely impact on Indian imports an (case ob : 39. What are fixed and flexible exchange rates ? (CBSE OD 15 20. Explain the meaning of managed floating exchange rate. (CBSE OD 2o1s, | 21. Describe any three sources of demand for foreign exchange. ; — 7 22. Give the meaning of ‘devaluation and depreciation’ of domestic currency. ae 150) | 23. ‘Devaluation and Depreciation of currency is one and the same thing’. Do you agree ow do they af 0 the exports of a country ? os LONG ANSWER TYPE QUESTIONS (6 Marks) | 1. Briefly discuss the Managed Floating Rate System. 2. Discuss in detail the major reasons for demand and supply of foreign exchange. 3. What isa foreign exchange market ? Discuss the major functions of foreign exchange market 4. How is exchange rate determined under a flexible exchange rate regime ? - Explain the effect of appreciation and depreciation of currency on foreign trade, § How do excess demand and excess supply of foreign exchange affect foreign exchange rate ? 7 Define fixed exchange rate. How is the exchange rate determined in a flexible exchange rate system ? 018) Introductory MACROECONOMICS-XIIChapter 11 : FOREIGN EXCHANGE PATE 349. An Extra Mile J HOW DOES INTEREST RATE DETERMINE THE EXCHANGE RATE «NCERT) In the short run interest rate differential (the difference between interest rates between countries) becomes an important factor in determining exchange rate movements. The huge funds possessed by private firms, households, banks, MNC’s move around the world fn search of the highest rates of interest. If itis assumed that government bonds in country A pay 10 per cent rate of interest whereas equally safe bonds in country B yield 12 per cent, the interest rate differential is 2 per cent. Investors from country A will be attracted by the high interest rates in country B and will buy the currency of country B selling their own currency. At the same time investors in country B will also find investing in their own country more attractive and will therefore demand less of country A’s currency. This means that the demand curve for country A’s currency will shift to the left and the supply curve will shift to the right causing a depreciation of country 4’s currency and an appreciation of country B’s currency. Thus, a rise in the interest rates at home often leads to an appreciation of the domestic currency. Here, the implicit assumption is that no restrictions exist in buying bonds issued by foreign governments. 2 SOME OTHER EXCHANGE RATE SYSTEMS Other than fixed, flexible and managed floating exchange rate systems, there are other types also, they are : (a) Crawling Peg System. In this system, a country specifies the parity value of its currency and allows small variation (41%) around this parity for a fixed time period. Ceiling and floor limits are set to maintain discipline. () Adjustable Peg System. In this system, member countries peg (fix) their currencies’ rate of exchange against one particular currency. This rate could be allowed some adjustments. The exchange rate is allowed variation within a margin of 1%. 3 SOME RELATED CONCEPTS OF EXCHANGE RATE Different concepts of exchange rate. There are four concepts related to exchange rate. (Nominal Exchange Rate (NER). The price of foreign currency in terms of domestic currency is known as Nominal Exchange Rate (NER). It is nominal because it expresses the exchange rate in money terms : 1$ = 50. (ii) Nominal Effective Exchange Rate (NEER). It i weighted average of nominal rates, ¢.8 if India's trade share with USA is 60% and with Japan is 40% and NER is %50 per dollar and 70 per Yen, then NEER = 60%(50) +40%(70) =30 +28 = %58. Introductory MACROECONOMICS-XIl350 UNIT V : BALANCE OF PAYMENTS (iii) Real Exchange Rate (RER). It is the ratio of foreign price level to domestic price level, measured in the same currency. (To make it comparable). P, =Domestic price level (Relative purchasing power of two currencies is measured by the relative exchange rate) s weighted average of RER for all the trading (iv) Real Effective Exchange Rate (REER). It is R i respective countries in foreign partners. Weights are accorded according to the share of trade.