Exchange Rate System

1. EXCHANGE RATE SYSTEM

2. TYPES OF EXCHANGE RATE SYSTEM
• I.Fixed Exchange Rate System – exchange rate is determined by the Central Bank of
the country
• Devaluation – fall in the value of a currency by official action
• Revaluation – rise in the value of a currency by official action
• Egs – Gold Standard , Bretton Woods System

3. • II. Flexible Exchange Rate System – exchange rate or the value of a currency is
determined by market forces of demand and supply of foreign exchange.
• Appreciation – rise in the value of a currency in terms of a foreign currency under
flexible exchange rates
• Depreciation – fall in the value of a currency in terms of a foreign currency under
flexible exchange rates

4. • III Managed Float Exchange Rate System – though exchange rate is determined
by market forces of demand and supply, central banks intervene in foreign
exchange markets to influence the exchange rates and to keep fluctuations within
reasonable limit
• Fluctuations in exchange rate effect the real sector (exports, imports) hence,
balance of payment
• Intervention in forex markets effects money supply and price stability
• Central banks Sterilise this intervention by selling government securities to banks.
Eg Market Stabilization Scheme (2004) in India
• Provides stability to foreign trade, capital flows and balance of payments
• However, central banks need adequate reserves of foreign exchange

5. DETERMINATION OF EXCHANGE RATE BETWEEN
$ AND ₹
• Demand for $ - from importers,
Indians travelling abroad, for direct
and portfolio investments abroad
Diagram
• Supply of $ - from exporters, foreign
travellers, FDIs and FPIs
Diagram

6. FACTORS AFFECTING EXCHANGE RATE
DETERMINATION

7. 1.INFLATION
Domestic products become relatively more
expensive
Reduces export, encourages imports

8. 2. INTEREST RATES
Rise in interest rates on bonds, securities
attracts foreign capital looking for high
returns

9. 3. CAPITAL INFLOWS
Higher returns, favourable government
policies for attracting FDIs like structural
reforms, reduction in taxes, disinvestment,
improvement in the ease of doing business
etc

10. 4. CAPITAL
OUTFLOWS
Political instability, higher returns on assets
in other economies, lower returns on
investments

11. OTHER DETERMINANTS
• Export promotion measures like export subsidies, tax concessions, increased
demand for exports, remittances- increases supply of foreign exchange causing
currency appreciation
• International factors like US sanctions on Iran increasing oil prices, current account
deficits, increased demand for gold in India – increases demand for foreign
exchange causing currency depreciation