CBSE Class 12 Economics - Foreign Exchange Rate
Meaning of Foreign Exchange:
Any currency other than the domestic currency at all as foreign exchange.
FOREIGN EXCHANGE RATE
The foreign exchange rate is the rate at which domestic currency is exchanged for foreign currency it represents the price of one currency in terms of another currency.
For example, if one dollar can be Exchanged for Rs.72 as to an exchange rate.
Or ₹1= 0.0138$
When the value of the domestic currency falls in town, it is known as currency appreciation.
For example, the rupee is said to be the price of one dollar rises from ₹72 to ₹75.
This is currency depreciation as initially you need to spend ₹72 to buy 1 dollar you need to spend Rs.75 by one dollar higher price to be paid for one dollar currency depreciation.
Effect of depreciation of domestic currency on exports:
- When currency deposition occurs, exports rises as now more rupees can be purchased the same one dollar.
When the value of the domestic currency rises in terms of foreign currency, it is known as currency appreciation.
For example, Rupee is said to be appreciating if the price of one dollar falls from ₹.72 to ₹17.
This is currency appreciation as we need to spend Rs.70 for 1 Dollar whereas now we need to spend just ₹70 for same one dollar.
Effect of appreciation on the domestic currency on imports:
- When currency appreciation occurs imports rises as we are required to buy one dollar.
Types of foreign exchange rates.
The three main types of exchange rate system are
- Fixed exchange rate system
- Flexible exchange rate system for a floating exchange rate system
- Managed floating rate system
It is the system under which the exchange rate for a currency is fixed by the government.
FIXED EXCHANGE RATE SYSTEM
This system is adopted in order to ensure stability in foreign trade and capital movements.
In order to maintain stability, the government undertakes to buy foreign exchange when the exchange becomes weaker cancel exchange currency when the rate of exchange get stronger.
For this government needs to maintain huge reserves of foreign exchange.
Pegging: When will you exchange is tied to our foreign currency it is called pegging.
Parity value: When the value of domestic currency is tied to value or some other currency in terms of gold it is called as parity value of currency.
Devaluation:When value of domestic currency is reduced by government it is called devaluation
Revaluation: It is the opposite of devaluation when value of domestic currency is increased by government it is called revaluation.
FLEXIBLE EXCHANGE RATE SYSTEM
- Flexible exchange rate system refers to a system in which foreign exchange rate is fixed by market forces of demand and supply of different currencies in the foreign exchange market
- The share price of foreign exchange currency fluctuate according to change in demand and supply of foreign currency
- The government never interfere in the system
-It is also called the floating exchange rate.
MANAGED FLOATING RATE SYSTEM
- It requires a system under which the foreign exchange rate is determined by market forces of demand and supply, and central bank influence the exchange rate through intervention in the foreign exchange market.
-This system is a mix of fixed and floating exchange rate system.
- In order to control the fluctuations, central bank intervenes in the foreign exchange market to ascertain level.
- For this central bank needs to maintain huge reserves of form exchange with them.
-This system is also known as dirty floating exchange rate system.
Demand for Foreign Exchange:
People need an exchange in order to make payments to foreign countries. It is demanded due to the following reasons:
1. Import of goods and services- when you need to import something from some foreign country, you need the foreign currency of that country to make payments to the seller.
2. Tourism - the foreign exchange is also required to meet expenditure incurred on foreign tours.
3. Unilateral transfer to abroad- the foreign exchange is required to send gifts and other payments which are unilateral in nature.
4. Purchase of assets in foreign countries- the foreign exchange is required to make payments for the purchase of assets like land shares et cetera in foreign countries.
5.Speculation- when people want to earn profit due to fluctuation in the price of foreign exchange, the demand foreign exchange.
Reasons for rise in demand for foreign currency:
A) When prices for an exchange falls, imports from that foreign currency rise has now more goods can be bought with the same amount of money for example if the price of one US dollar falls from Rs.75 to Rs.71 then imports from the USA will become cheaper as now we just need to pay Rs.71 for one US dollar against the earlier price of Rs.75 for one US dollar.
B) When foreign currency becomes the cheaper entrance of domestic currency, he promotes tourism to that country. As a result, the demand for foreign currency rises.
C) When Price of foreign currency for its demand rises as more and more people want to make gains out of speculative activities.
Supply for foreign exchange
The supply of foreign exchange comes from those people who receive it due to the following reasons.
1.Export of goods and services - when you export something you see foreign currency and that’s when former change comes from.
2. Foreign investment- when any foreigner invest in our country they invest in the domestic currency and we receive foreign exchange.
3.Remittance unilateral transfers from abroad- When we receive any remittance from abroad like gifts, grants , scholarship etc. Supplier for the change has increased.
4. Speculation- supply of foreign exchange also increases from those who want to earn some profit out of speculation.
Reasons for rise in supply of foreign currency:
1. In case of rise in price of foreign currency domestic goods become relatively cheaper, which increases imports from diverse the country and hence supply for foreign exchange rises four example, initially price of one dollar was equal to Rs.72, now it can be exchanged for Rs.75 for one dollar now is the same one dollar foreign country can import goods what are Rs.75 incident of 72 i.e. more goods for the same price.
2. When the price of forex rises so does the scope of making gains out of speculative activities increases and hence apply a full exchange rises.
Supply curve of foreign exchange:
Shift and supplier for a change, the supply curve slopes upwards from left to right.
DETERMINATION OF FOREIGN EXCHANGE RATE-
Exchange rate under flexible exchange rate is data mined through market forces of demand and supply. Has clearly shown in the diagram exchange rate is it my point EV a demand curve and supply curve it affects each other.
At any point above equilibrium, there is the tuition of excess supply and at any point below one UBM, there is a situation of excess demand.
CHANGE IN EXCHANGE RATE
Exchange rate changes when there is a change is in either demand or supply or both.
Change in demand.
Change in demand can either increase in demand decrease in demand.
Increase in demand - when demand for foreign exchange increases demand curve shifts right word from DD to D1D1 and price rises from OP1 to OP2 And equilibrium quantity also rises from OQ1 TO OQ2.
Decrease in demand- When demand for foreign exchange falls, demand curve DD shifts leftwards from DD to D1D1. And equilibrium price falls from OP to OP1 and quantity also falls from OQ to OQ1.
Change in supply
Change in supply chain supply can either be increase or decrease in Supply.
Increase in supply - When the supply of foreign exchange increases, supply curve shifts right words from SS to S1S1 and quantity supplied rises from 0Q to 0Q1 wherever the price of unexplained falls from OP to OP1.
Decrease in supply - When the supply of foreign exchange falls, it shifts leftwards from SS to S1S1 whereas quantity falls from 0Q to 0Q1 and price rises from OP to OP1.
FOREIGN EXCHANGE MARKET
A place where foreign exchange is bought and sold. Here buyer and seller include commercial as well as the central bank, individuals, firms, foreign exchange broker, etc.
Functions of the Foreign Exchange market:
1.Transfer Function- it transfers purchasing power between countries involved in the transaction. This function is performed using bills of form exchange, bank drafts, and telephonic transfers.
2. Credit function -it provides credit for foreign trade. Bills of exchange, with a maturity period of three months, are generally used for International payments. Credit is required, for this period in order to enable the importer to take possession of the goods, sell them and obtain money to pay all the bills.
3.Hedging function - when importer and exporter enter into an agreement to exchange goods on a future date at a price fixed today. The purpose of hedging is to avoid a loss that might occur due to exchange rate fluctuations.
KINDS OF FOREIGN EXCHANGE MARKET:
-Spot market upon exchange market where is it and payments are made immediately stamp have spot market.
The rate prevailing in the spot market is termed as the spot rate or current rate of exchange.
-Forward market how foreign exchange market where transactions are made what a future specified in the price of today is a forward market. The exchange rate quoted in forward transactions is known as forward exchange rate.
The basic features of forward market are-
1.It avoids lost, which occurs due to fall exchange rate fluctuations through hedging.
2.To make profit out of speculation