Foreign Exchange Rate:
Meaning of Exchange Rate:
- The currency of one country is generally accepted within the boundary of that country, but not in another country. Therefore, the trade between nations can take place only if it is possible to exchange the currency of one country for that of another.
- Foreign currencies and claims on them in the form of bank deposits, cheques etc., payable in those currencies is known as foreign exchange.
- Thus foreign exchange refers to foreign currencies eg. US dollars, British Pounds are foreign exchange for India.
- Foreign Exchange Market:
The market where foreign exchange is traded is known as foreign exchange market.
- Exchange Rate:
Exchange rate refers to the rate at which the currencies of different countries are traded or exchanged.
- Exchange rate is the price of one currency expressed in terms of another currency.
- Example, if to get 1 American dollar, you have to pay 50 Indian rupees, then the rate of exchange between two currencies is 1 dollar = 50 rupees
Exchange Rate System:
1. Fixed Exchange Rate System
2. Flexible Exchange Rate System
1. Fixed Exchange Rate System:
- In fixed exchange rate system, the rate of exchange is officially fixed by the central bank of the country by official action.
- In fixed exchange rate system the rate does not vary with the change in demand and supply of foreign currency.
- Central bank of the country intervenes in the foreign exchange market to hold the exchange rate at some preannounced level.
- Intervention of the central bank is in the form of buying and selling of foreign exchange.
- In order to fix the exchange rate, the central bank has to hold reserve of foreign exchange or foreign currencies so as to provide foreign exchange in exchange for the domestic currency.
- The central bank buys foreign currencies at the fixed exchange rate when there is excess supply of foreign exchange and sells it when there is excess demand for foreign exchange.
- The exchange rate does not always remains absolutely fixed. Depending upon the circumstances and the state of the economy the central bank may revise the exchange rate. But the rate of exchange is changed as a policy decision.
2. Flexible Exchange Rate System:
- In a flexible exchange rate system, exchange rate is left free to be determined in the foreign exchange market by the forces of demand and supply.
- In this state, the central bank allows the exchange rate to adjust to equate the demand and supply of foreign exchange.
- This system is also known as floating exchange rate system.
- There are two types of floating :
1. Clean Floating
2. Dirty or Managed Floating
- In clean floating – the central bank stands said completely and allows exchange rate to be freely determined in the foreign exchange market.
- Under managed or dirty floating, central bank intervenes to buy and sell foreign currencies in an attempt to influence the exchange rate.
- In most of the countries including India managed type of flexible exchange rate system is adopted.
Concepts of Depreciation, Appreciation, Devaluation and Revaluation:
Depreciation:
- Depreciation refers to a fall in the free market value of domestic currency relative to the currencies of other countries in the foreign exchange market.
- Example, if 1 dollar is exchanged for Rs 55, is now for Rs. 60
1 dollar = Rs. 50 becomes
1 dollar = Rs. 60
- It means domestic currency becomes less expensive relative to foreign currencies.
- This term is applied when exchange rate is flexible.
2. Appreciation:
- Appreciation means a rise in the free market value of domestic currency relative to currencies of other countries in the foreign exchange market.
- Eg. The rate of exchange changes from Rs. 65 per dollar to Rs 60 per dollar, it means the appreciation of Indian rupees.
- This term is used when exchange rates are flexible.
3. Devaluation:
- Devaluation refers to an action of the central bank to decrease the value of domestic currency relative to the currencies of other countries under a system of fixed exchange rate.
- Devaluation of a currency means that the residents of devaluing country pay more for foreign currencies.
- This term is used when exchange rate are fixed.
Revaluation:
- Revaluation refers to an action of the central bank to raise the value of domestic currency relative to other currencies under a system of fixed exchange rate.
Relationship between the foreign exchange rate and the domestic price of traded goods:
- The change in the exchange rate affects the domestic prices of traded goods.
- When the rate of exchange of foreign currency increases and that of domestic currency decreases and there is a depreciation of domestic currency.
- Depreciation or devaluation increases the domestic price of imported goods.
- On the other hand, appreciation decreases the domestic price of imported goods.
- Example, if the rate of exchange of US dollar is Rs 50 to 1 dollar. Then an American jeans of 20 dollars costs Rs 1000 ( = Rs. 50 × $20 ).
- If the exchange rate increases to Rs. 60 to $ 1, then the same jeans will cost Rs. 1200 (= 60 × 20 = 1200) in India which becomes costlier.
- If the exchange rate decrease to Rs. 45 to $ 1, then the same jeans will cost Rs 900 (= 45 × 20 = 900), which means it becomes cheaper.
Influence of Exchange Rate on Imports and Exports:
- An increase in rate of exchange will cause depreciation of domestic currency which increase the domestic price of imported goods.
- An increase in import prices leads to a fall in the demand for imports.
- Example, when exchange rate of dollar increases from Rs. 50 to $1 to become Rs. 60 for $1. The price of jeans costs $20 will become Rs. 1200 from Rs. 1000. Which discourage the purchase of imported jeans.
- A decrease in exchange rate means appreciation of domestic currency will decrease the domestic price of imported goods. This will encourage the purchase of imported good. At the same time this leads to decrease in export because of increase in the price of exported goods.
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