What is Foreign Exchange?
Foreign Exchange refers to all currencies other than the domestic currency of a given country.
For example, India’s domestic currency is Indian rupee and all other currencies like: US Dollar, Brit!, h Pound, Kuwaiti Dinar etc. are foreign exchange.
FOREIGN EXCHANGE RATE
Foreign exchange rate represents the price of one currency in terms of another currency in terms of another currency, Foreign Exchange Rate refers to the at which one currency is exchanged for the other
$ 1 = Rs. 40
Rs. 1 =1/40 Dollars = 0.025 Dollar
Types of Foreign Exchange Rates
The three main types of exchange rate systems are:
1. Fixed exchange rate system (also known as pegged exchange rate system).
2. Flexible exchange rate system (also known as floating exchange rate system).
3. Managed floating rate system. (Also known as dirty floating exchange rate system)
1. Fixed exchange rate system:
The system in which the foreign exchange rate is officially fixed by the government/monetary authority and not determined by markets forces.
In earlier times, exchange rates of all major countries were fixed according to the Gold Standard.
Merits:
(i) It ensures stability in exchange rate which encourages foreign trade.
(ii) It contributes to the coordination of macro policies of countries in an interdependent world economy.
(iii) Fixed exchange rates prevents capital outflow.
(iv) It prevents speculation in foreign exchange market.
(v) Fixed exchange rates are more conductive to expansion of world trade because it prevents risk and uncertainty in transactions.
Demerits:
(i) There is a fear of devaluation in situation of excess demand.
(ii) Benefits of free markets are deprived.
(iii) There is always possibility of undervaluation or overvaluation.
2. Flexible Exchange Rate:
Flexible exchange rate is the rate which is determined by forces of supply and demand in the foreign exchange market.
There is no official (govt.) Intervention.
Here the value of a currency is left completely free to be determined by market forces of demand and supply of foreign exchange.
Merits:
(i) Deficit or surplus in BOP is automatically corrected.
(ii) There is no need for government to hold any foreign reserve.
(iii) It helps in optimum resource allocation.
(iv) It frees the government from problem of balance of payment.
(v) Flexible exchange rate increases the efficiency in the economy by achieving best allocation of resources.
Demerits:
(i) It encourages speculation leading to fluctuation in exchange rate.
(ii) Wide fluctuations in exchange rate can hamper foreign trade and capital movement between countries.
(iii) It generates inflationary pressure when prices of imports go up due to depreciation of the currency caused by deficit in BOP.
(iv) It discourages investment and international trade.
3.Managed floating rate system
Managed floating exchange rate is a mixture of a flexible exchange rate (the float and a fixed exchange rate.
In other words, it refers to a system in which foreign exchange is determined by free market forces (demand and supply forces), which can be influenced by the intervention of the central bank in foreign exchange market.
Dirty floating: If the countries manipulate the exchange rate without following the guidelines issued by the I.M.F is called as dirty floating.
Demand for Foreign Exchange
Demand (outflow) for foreign exchange arises due to the following reasons
1. Import 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 undertake foreign tour.
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: Foreign exchange in needed to make payment for the purchase of assets (like land, building, share, bonds etc.) in foreign countries.
5. Speculation: Demand for foreign exchange arises when people want to make gains from appreciation of the currency.
Supply of Foreign Exchange
Supply (inflow) of foreign exchange comes from the following sources.
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. Remittance (Unilateral transfers) from abroad: Supply of foreign exchange increase in the form of gift and other remittances from abroad.
4. Speculation: Supply of foreign exchange comes from those who want to speculate on the value of foreign exchange.
5. Foreign tourism in our country.
Equilibrium Rate of Exchange
The equilibrium exchange rate is determined at a level where demand for foreign exchange is equal to the supply of foreign exchange.
In the diagram, demand and supply of for exchange are measured on the X-axis, and the rate of foreign exchange is measured on the Y-axis.
DD is the downward sloping demand curve of foreign exchange and SS is the upward sloping supply curve of foreign exchange.
Foreign Exchange Market
Foreign exchange market is the market in which foreign currencies are bought and sold.
Functions of Foreign Exchange Market
Foreign exchange market performs the following three functions.
1. Transfer Function: Foreign exchange market transfers purchasing power between the countries involved in the transaction.
This function is performed through credit instruments like bills of foreign exchange, bank drafts and telephonic transfers.
2. Credit Function: Foreign exchange market provides credit for foreign trade.
Bills of exchange, with maturity period of three months, are generally used for international payments.
Thus, credit is required for this period to enable the importer to take possession of goods, sell them and obtain money to pay off the bill.
3. Hedging Functions:Hedging in an important function of foreign exchange market.
When exporter and importers enter into an agreement to sell and buy gods on some future date at the current prices and exchange rate, it is called hedging.
The purpose of hedging is to avoid losses that might be caused due to exchange rate variations in the future.
- It is a situation when value of domestic currency falls in comparison to foreign currency.
- More of domestic currency is required to get one unit of foreign currency.
- Domestic currency becomes weaker.
- Exports increase, Imports decrease.
- It may be due to increase in demand or decrease in supply of foreign exchange.
- It is a situation when value of domestic currency rises in comparison to foreign currency.
- Less of domestic currency is required to get one unit of foreign currency.
- Domestic currency becomes stronger.
- Exports decrease, Imports increase.
- It may be due to decrease in demand or increase in supply of foreign exchange.
- Depreciation of currency occurs due to increase in demand or decrease in supply of foreign exchange, while Devaluation is done by government.
- New equilibrium exchange rate is set due to depreciation, Devaluation may not necessarily be the equilibrium rate.
- Appreciation of currency occurs due to decrease in demand or increase in supply of foreign exchange, while Revaluation is done by government.
- New equilibrium exchange rate is set due to depreciation, Revaluation may not necessarily be the equilibrium rate.
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