Foreign Exchange Rate
Meaning of Exchange Rate
• The concept of exchange rate has great significance because in case of the open
economy transactions there is an existing of at least two currency.
• Exchange rate refers to the price of one national currency expressed in terms of any
other foreign currency.
• External economic transactions need an essential symmetry between two currencies
Definition of Exchange Rate
• Exchange Rate can be defined as, "the amount of the foreign currency that may be
bought for one unit of the domestic currency."
• It can also be defined as, "the cost in domestic currency of purchasing one unit of the
foreign currency."
• Suppose the exchange rate between Indian Rupee and the U.S. Dollar is expressed as
Re. 1 = $0.0211227 or $ 1 = Rs.47.
• It simply means the value of one Indian Rupee is 0.02127 dollars or in other words one
dollar costs Rs.47.
• Thus, exchange rate is the price of one currency expressed in any other currency. In
order to simplify the fulfillment of international transactions an expression of exchange
rate is must in external economic transactions
Determination of Exchange Rate
• Since the foreign exchange rate is a price, economists apply supply-demand conditions
of price theory in the foreign exchange market.
• A simple explanation is that the rate of foreign exchange equals its demand for and
supply of foreign exchange.
Demand for Foreign Exchange
• The demand (or outflow) of foreign exchange comes from those people who need it to
make payment in foreign currency.
• It is demanded by the domestic residents for the following reasons:
• 1. Imports of Goods and Services:
• Foreign Exchange is demanded to make the payment for imports of goods and services.
• 2. Tourism:
• Foreign exchange is needed to meet expenditure incurred in foreign tours.
• 3. Unilateral Transfers sent abroad:
• Foreign exchange is required for making unilateral transfers like sending gifts to other
countries.
• 4. Purchase of Assets in Foreign Countries:
• It is demanded to make payment for purchase of assets, like land, shares, bonds, etc. in
the foreign countries.
• 5. Speculation:
• Demand for foreign exchange arises when people want to make gains -from
appreciation of currency.
• Demand Curve of Foreign Exchange:
• Demand curve of foreign exchange slope downwards due to inverse relationship
between demand for foreign exchange and foreign exchange rate.
• In Fig. 11.1, demand for foreign exchange (US dollar) and rate of foreign exchange are
shown on the X- axis and Y-axis respectively. The negatively sloped demand curve (DD)
shows that more foreign exchange (OQ1) is demanded at a low rate of exchange (OR1),
whereas, demand for US dollars falls to OQ2 when the exchange rate rises to OR2.
Supply of Foreign Exchange
• The supply (inflow) of foreign exchange comes from those people who receive it due to
following reasons.
• 1. Exports of Goods and Services:
• Supply of foreign exchange comes through exports of goods and services.
• 2. Foreign Investment:
• The amount, which foreigners invest in the home country, increases the supply of
foreign exchange.
• 3. Remittances (Unilateral transfers) from abroad:
• Supply of foreign exchange increases in the form of gifts and other remittances from
abroad.
• 4. Speculation:
• Supply of foreign exchange comes from those who want to speculate on the value of
foreign exchange.
• Supply Curve of Foreign Exchange:
• Supply curve of foreign exchange slope upwards due to positive relationship between
supply for foreign exchange and foreign exchange rate.
• In Fig. 11.2, supply of foreign exchange (US Dollar) and rate of foreign exchange have
been shown on the X-axis and Y-axis respectively. The positively sloped supply curve (SS)
shows that supply of foreign exchange rises from OQ1 to OQ2 when the exchange rate
rises from OR, to OR2.
• The Equilibrium Exchange Rate:
• It will be seen from Figure 28.1 that the equilibrium exchange rate, that is, the
equilibrium price of dollar in terms of rupees is equal to OR or 61.50 per dollar at which
demand for and supply curve of dollars intersect and therefore the market for dollars is
cleared at this rate.
• At a higher price of dollars OR’ or Rs.63, the quantity supplied of dollars exceeds the
quantity demanded. With the emergence of excess supply of dollars, its price, that is,
the exchange rate will again fall to OR or Rs. 61.50.
• On the other hand, if the rate of exchange is lower than OR, say it is OR” or Rs. 60 to a
dollar, there will emerge the excess demand for dollars. This excess demand of dollars
would push up the price of dollars to the level of OR or Rs. 61.50 per dollar.
Main Causes of Fluctuations in Exchange Rates
• Foreign Exchange rate is one of the most important means through which a
country’s relative level of economic health is determined.
• A country's foreign exchange rate provides a window to its economic
stability, which is why it is constantly watched and analyzed.
• It may fluctuate daily with the changing market forces of supply and
demand of currencies from one country to another.
• The leading factors that influence the variations and fluctuations in
exchange rates are given below
• 1. Trade Movements:
• Any change in imports or exports will certainly cause a change in the rate of
exchange. If imports exceed exports, the demand for foreign currency rises;
hence the rate of exchange moves against the country.
• Conversely, if exports exceed imports, the demand for domestic currency
rises and the rate of exchange moves in favour of the country
•
• 2. Capital Movements:
• International capital movements from one country for short periods to avail
of the high rate of interest prevailing abroad or for long periods for the
purpose of making long-term investment abroad.
• Any export or import of capital from one country to another will bring
about a change in the rate of exchange.
•
• 3. Stock Exchange Operations:
• These include granting of loans, payment of interest on foreign loans,
repatriation of foreign capital, purchase and sale of foreign securities e c.,
which influence demand for foreign funds and through it the exchange
rates.
• For instance, when a loan is given by the home country to a foreign nation,
the demand for foreign money increases and the rate of exchange tends to
move unfavourably for the home country.
• But, when foreigners repay their loan, the demand for home currency
exceeds its supply and the rate of exchange becomes favourable.
• 4. Speculative Transactions:
• These include transactions ranging from anticipation of seasonal
movements in exchange rates to the extreme one, viz., flight of capital.
• In periods of political uncertainty, there is heavy speculation in foreign
money.
• There is a scramble for purchasing certain currencies and some currencies
are unloaded.
• Thus, speculative activities bring about wide fluctuations in exchange rates.
• 5. Banking Operations:
• Banks are the major dealers in foreign exchange. They sell drafts, transfer
funds, issue letters of credit, accept foreign bills of exchange, take up
arbitrage, etc. These operations influence the demand for and supply of
foreign exchange, and hence the exchange rates.
• 6. Monetary Policy:
• An expansionist monetary policy has generally an inflationary impact, while
a constructionist policy tends to have a deflationary inflation.
• Inflation and deflation bring about a change in the internal value of money.
This reflects in a similar change in the external value of money.
• Inflation means a rise in the domestic price level, fall in the internal
purchasing power of money, and hence a fall in the exchange rate.
• 7. Interest Rates
• Changes in interest rate affect currency value and dollar exchange rate.
Forex rates, interest rates, and inflation are all correlated.
• Increases in interest rates cause a country's currency to appreciate because
higher interest rates provide higher rates to lenders, thereby attracting
more foreign capital, which causes a rise in exchange rates
• 8.Country’s Current Account / Balance of Payments
• A country’s current account reflects balance of trade and earnings on
foreign investment. It consists of total number of transactions including its
exports, imports, debt, etc.
• A deficit in current account due to spending more of its currency on
importing products than it is earning through sale of exports causes
depreciation. Balance of payments fluctuates exchange rate of its domestic
currency.
• 9.Government Debt
• Government debt is public debt or national debt owned by the central
government. A country with government debt is less likely to acquire
foreign capital, leading to inflation.
• Foreign investors will sell their bonds in the open market if the market
predicts government debt within a certain country. As a result, a decrease
in the value of its exchange rate will follow.
• 10.Political Conditions:
• Political stability of a country can help very much to maintain a high
exchange rate for its currency; for it attracts foreign capital which causes
the foreign exchange rate to move in its favour.
• Political instability, on the other hand, causes a panic flight of capital from
the country hence the home currency depreciates in the eyes of foreigners
and consequently, its exchange value falls.
• 11.Terms of Trade
• Related to current accounts and balance of payments, the terms of trade is
the ratio of export prices to import prices.
• A country's terms of trade improves if its exports prices rise at a greater
rate than its imports prices.
• This results in higher revenue, which causes a higher demand for the
country's currency and an increase in its currency's value. This results in an
appreciation of exchange rate.
• 12.Recession
• When a country experiences a recession, its interest rates are likely to fall,
decreasing its chances to acquire foreign capital. As a result, its currency
weakens in comparison to that of other countries, therefore lowering the
exchange rate.
