A fantastic PPT on the foreign exchange rate. The PPT includes meaning and concept of foreign exchange and foreign exchange rate, the systems of determining foreign exchange rate, depreciation of domestic, appreciation of domestic currency, devaluation and revaluation of domestic currency. This PPT also explain the role of RBI in managing the exchange rate by using the concept of managed floating. Just download it and make your concepts stronger. Happy Learning !!

1. Unit – 5
(6 Marks)
Chapter-1
Foreign Exchange
Rate

3. Introduction
● In a modern set up of today’s world, all countries
have economic relations with other countries. There
is increasing interdependence among all countries.
● As each country has its own currency, domestic
currency of a country cannot be used directly in any
other country. It has to be converted into currency
of the other country and then to be used in
transactions.

4. Meaning of Foreign Exchange
Foreign Exchange
It refers to the stock of:
(a) Foreign currencies
(b) Securities and bonds issued by
foreign corporates and government.

5. • The rate at which currency of one country is
exchanged for the currency of other country
is known as foreign exchange rate.
• It is the price of one currency in terms of
another.
• It represents the external purchasing power
of a currency. It is the rate at which exports
and imports of a nation are value at a given
point of time.
Meaning of Foreign Exchange
Rate

6. Types of Foreign Exchange
Rate System
(A) Fixed Exchange Rate System
• It is the system in which the rate of exchange for
a currency is officially fixed by the government.
Under this system, government is responsible to
stabilize the exchange rate.
• Under this system, each country maintains value
of its currency fixed in terms of gold, silver, other
precious metal, another country’s currency etc.
• There are two systems of fixed exchange rate:-
(i) Gold standard system of exchange rate
(ii) The Bretton Woods System

7. (i) Gold standard system of fixed exchange rate
According to this system, gold was taken as the
common unit of parity between currencies of
different countries. Each country defined value of
its currency in terms of gold.
For example, if 1₤ (U.K. Pound) = 2 g of gold and
1$ (U.S. Dollar) = 1 g of gold then exchange rate
would be 1 U.K. ₤ = 2 U.S $.

8. (ii) Bretton Woods System/ Adjustable Peg
System – This system was adopted to have
transparency in the system. Under this system, all
currencies were related to US dollar which ultimately
was convertible into gold.
• IMF worked as central institution in controlling the
system.
• It is called ‘adjustable peg system’ because it
allowed some adjustments but only if allowed by IMF.

9. Merits of Fixed Exchange Rate
(i) It ensures stability in the exchange market.
(ii) It implies low risk and low uncertainty for future
payments.
(iii) Coordination of macroeconomic policies across
different parts of the world becomes convenient.
(iv) It prevents speculation in foreign exchange market.
Demerits of Fixed Exchange Rate
(i) Government has to maintain 100% gold reserves.
(ii) It restricts the movement of capital across different
parts of the world. Since exchange rate is fixed,
investment is also fixed and the international growth
suffers.
(iii) There is possibility of under or over valuation of the
currency.
(iv)It does not encourage venture capital.

10. Flexible/ Floating Exchange Rate
System
• It is the system of exchange rate in which exchange
rate between currencies of different countries is
determined by the market forces of demand and
supply.
• There is no official interference by the Govt. in the
foreign exchange market.
• It is called flexible because it tends to change with
changes in market forces of demand and supply.
• The exchange rate at which demand for foreign
currency is equal to its supply is called Par Rate of
Exchange, Normal Rate or Equilibrium Rate of
Foreign exchange.

11. Merits of Flexible Exchange Rate System
(i) This system is not to be supported with
international reserves of gold.
(ii) It solves the problem of overvaluation or
undervaluation of currencies.
(iii) It promotes venture capital in the foreign
exchange market. Trading in international
currencies itself become an important economic
activity.
(iv) Promotes movement of capital across different
parts of the world.

12. Demerits of Flexible Exchange Rate System
(i) There is no stability. Flexible exchange rate keep
fluctuating according to demand and supply.
(ii) Instability in the foreign exchange market cause
instability in the area of international trade.
(iii) Coordination of macroeconomic policies become
inconvenient due to day to day fluctuation in
exchange rate.

13. • Fixed exchange rate is fixed in terms of gold, or
any other currency by the government, whereas,
flexible exchange rate is determined by the
market forces of demand and supply of foreign
currency.
• Fixed exchange rate does not change with
changes in demand and supply whereas flexible
exchange rate changes with changes in demand
and supply of foreign exchange rate.

14. • The theory of determination of rate of exchange is
the demand and supply theory.
• According to this theory, the rate of exchange of a
country's currency is determined by the demand
and supply of foreign exchange.
R = f (D, S)
where, R – Exchange Rate
D – Demand of different currencies in
the international market.
S – Supply of different currencies in the
international market.
Determination of Flexible Exchange
Rate System

15. Sources/Determinants of Demand for
Foreign Currency
• Payment in foreign exchange causes demand for
foreign exchange.
• Foreign exchange is demanded for the following
reasons:
(a) To purchase goods and services from foreign
countries.
(b) To purchase financial assets in foreign countries.
(c) To send gifts and grants to abroad.
(d) Remittances by foreigners working in India.
(e) To undertake foreign tours.
(f) To make payments of interest on loans and repay
the international loans.

16. ▪ There is an inverse relationship between the price
of foreign exchange and demand for foreign
exchange.
Exchange Rate ↑ - ↓ Demand
Exchange Rate ↓ - ↑ Demand

17. • At OR rate of foreign exchange, OM quantity of
foreign exchange is demanded.
• It would be seen from above figure, a rise in the
price of foreign exchange (OR – OR1) will result in
a fall in the demand for foreign exchange
(OM – OM1).
• Similarly, if the price of foreign exchange falls,
from (OR – OR2) more of the dollars would be
demanded (OM - OM2).

18. Sources/Determinants of Supply of
Foreign Currency
• Supply of foreign exchange comes from foreigners
who make us payments in foreign exchange for
different purposes.
• Following factors cause supply of foreign
exchange:
(a) Exports of goods and services to ROW.
(b) Foreign tourists spend in foreign exchange in our
country.
(c) Foreign Direct Investment by Multinational
Companies.
(d) Direct purchase of shares and bonds by the
foreign investors in India.

19. (e) Remittances by Indians working in abroad.
(f) Deposits by NRI’s leads to flow of foreign
exchange in the Indian foreign exchange market.
• There is direct relationship between prices of foreign
exchange and supply of foreign exchange.
Exchange Rate ↑ - ↑ Supply of Foreign Exchange
Exchange Rate ↓ - ↓ Supply of Foreign Exchange

20. • At OR rate of foreign exchange, OM quantity of
foreign exchange is demanded.
• A rise in the price of dollars from OR to OR2 results
in more quantity of dollars being supplied, from
OQ to OQ2.
• Conversely, if the price of foreign exchange falls
from OR to OR1, quantity supplied of dollars will
fall from OQ to OQ1.

21. Determinantion of Equilibrium Rate of
Foreign Exchange (Flexible)
• Equilibrium exchange rate is determined at a point
where the quantity demanded and the quantity
supplied of foreign exchange are equal.
• This can be demonstrated with the help of figure
shown below, assuming foreign exchange is dollars.

22. Observations
• Negatively sloped demand curve (DD) and
positively sloped supply curve (SS) of foreign
exchange intersect each other at point E.
• Point E shows equilibrium between demand and
supply of foreign exchange.

23. • Point E corresponds to equilibrium rate of foreign
exchange which is OR. At this rate (OR), OM
quantity of foreign exchange is demanded and
supplied.
• At a price higher than equilibrium price, say OR2,
there will be excess supply (M1M2) of foreign
exchange in India’s foreign markets.
• This will push down the price (rate) of foreign
exchange (Indian rupee will tend to appreciate).
• It will cause extension in demand (Q to E) and
contraction in supply (P to E) till it reaches the
equilibrium position at OR.

24. • On the other hand, if the rate is lower than the
equilibrium price say OR1, it will give rise to
excess demand (M1M2) of foreign exchange.
• This will pull up the rate of foreign exchange
(Indian rupee will tend to depreciate). It will
cause extension in supply (T to E) and
contraction in demand (M to E) till it reaches the
equilibrium position at OR.

25. Causes of Change in Rate of
Foreign Exchange
The foreign exchange rate may rise or fall depending
changes in demand or supply of foreign exchange. In this
section we will understand:
(a) Currency Depreciation (When exchange rate rises)
(b) Currency Appreciation (When exchange rate falls)

26. (A) Depreciation of Domestic Currency
(Appreciation of Foreign Currency)
• Depreciation of currency refers to decrease in the
value of domestic currency in terms of foreign
currency.
• It occurs when there is an increase in the
domestic currency price to buy a unit of foreign
currency.
For example – if price of one dollar ($) rises from
Rs.50 to Rs.60. This is currency depreciation.

28. (i) Increase in demand for foreign exchange
Observations
• Due to increase in demand, DD curve shifts to right
(DD – D1D1).
• New equilibrium point E1 is achieved.
• It shows rise in exchange rate from OR – OR1.

29. (ii) Decrease in supply of foreign currency
Observations
• Due to decrease in supply, SS curve shifts to
left (SS – S1S1).
• New equilibrium point E1 is achieved.
• It shows rise in exchange rate from OR – OR1.
• It shows depreciation of currency.

30. Effect of Depreciation of Domestic Currency
on Foreign Trade (on Exports and Imports)
(a) Effect of depreciation on exports: It encourages
exports
• Deprecation of domestic currency means a fall in the
value of the domestic currency in terms of foreign
currency.
• It implies with the same one dollar, more of goods can
be purchased from India.
• It means exports by USA have become cheaper. This
will encourage the exports.

31. (b) Effect of depreciation on imports: It
discourages Imports
• Deprecation of domestic currency means a fall in
the price of domestic currency in terms of foreign
currency.
• It implies that more of domestic currency is required
to buy goods worth 1 US dollar.
• It means imports from USA have become costlier.
This will discourage the imports.

33. (B) Appreciation of Domestic Currency
(Depreciation of Foreign Currency)
• Appreciation of currency refers to increase in the
value of domestic currency in terms of foreign
currency.
• It occurs when there is a decrease in the domestic
currency price to buy a unit of foreign currency.
For example – if price of one dollar ($) falls from Rs.60
to Rs.50. This is currency appreciation.

35. (i) Fall in demand for foreign currency
Observations
• Due to decrease in demand, DD curve shifts to
left (DD – D2D2).
• New equilibrium point E2 is achieved.
• It shows fall in exchange rate from OR to OR2.
• It implies appreciation of currency.

36. (ii) Rise in supply of foreign currency
Observations
• Due to increase in supply, SS curve shifts to
right (SS – S2S2).
• New equilibrium point E2 is achieved.
• It shows fall in exchange rate from OR to OR2.
• It implies appreciation of currency.

37. Effect of Appreciation of Domestic Currency on
Foreign Trade (on Exports and Imports)
(a) Effect of appreciation on exports: It discourages
exports
• Appreciation of domestic currency means an increase
in the value of the domestic currency in terms of
foreign currency.
• It implies that with same one dollar, less goods can be
purchased from India.
• It will discourage exports by USA, therefore exports to
USA will decrease.

38. (b) Effect of appreciation on imports: It
encourages imports
• Appreciation of domestic currency means an
increase in the value of the domestic currency in
terms of foreign currency.
• It implies that for same one dollar, less units of
domestic currency are required.
• It encourage imports from USA, therefore imports
from USA will increase.

41. Devaluation and Revaluation of
Domestic Currency
• When a country brings down the value of its
currency in terms of foreign currency by a
government order, it is called devaluation of
domestic currency. The effect of devaluation is
the same as that of depreciation of the currency.
• When country raises the value of its currency in
terms of foreign currency by a government order,
it is called revaluation of domestic currency. The
effect of revaluation is the same as that of
appreciation of currency.

42. Difference between Depreciation and
Devaluation of Domestic Currency
Basis Depreciation of
Domestic Currency
Devaluation of
Domestic Currency
1. Meaning
2. Operation
3. System
Decrease in the value
of domestic currency
in terms of foreign
currency by market
demand and supply.
Takes place due to
market force of
demand and supply
of foreign exchange.
Flexible exchange
rate system.
Fall in the value of
domestic currency
by the Govt.
Takes place due to
the Govt. Order to
correct BOP
situation.
Fixed exchange rate
system.

43. Difference between Appreciation and
Revaluation of Domestic Currency
Basis Appreciation of
Domestic Currency
Revaluation of
Domestic Currency
1. Meaning
2. Operation
3. System
Increase in the value
of domestic currency
in terms of foreign
currency by market
demand and supply.
Takes place due to
market force of
demand and supply
of foreign exchange.
Flexible exchange
rate system.
Rise in the value of
domestic currency by
the Govt.
Takes place due to
the Govt. Order to
correct BOP
situation.
Fixed exchange rate
system.

44. Managed Floating
• It is a system in which the central bank allows the
exchange rate to be determined by market forces but
interferes at times to influence the exchange rate in
case of depreciation or appreciation of domestic
currency.
• Managed floating is a tool employed by the central
bank to restore the value of the country’s currency
within the desired limits, even when the exchange
rate is determined by the market forces of demand
and supply.

45. • Central bank does not have full power but some
power to manage exchange rate slightly
according to the economy.
• It is a system which allows adjustments in
exchange rate according to a set of rules and
regulations which are officially declared in foreign
exchange market.
• This system is a combination of fixed and flexible
exchange rate. Therefore, it is also called a
‘hybrid system’.
• If a country manipulates the exchange rate by
not following rules and regulations, it is called
dirty floating.

46. • During depreciation of domestic currency, the
central bank starts selling the US dollars in the
international market to restore the value of
domestic currency.
• During appreciation of domestic currency, the
central bank starts buying the US dollars in the
international market to restore the value of
domestic currency.
Depreciation - Sale of Foreign Currency
Appreciation - Purchase of Foreign Currency

48. An Extra Mile
I. Foreign Exchange Market
• Foreign exchange market refers to the market for
national currencies of different countries in the
world.
• It includes banks, specialized foreign exchange
dealers brokers and official govt. agencies
through which currency of one country can be
exchanged for that of another country.

49. (A) Spot market
• It refers to a market where current transactions in
foreign exchange take place.
• The market in which the receipts and payments
of foreign exchange are made immediately is
called spot market.
• It is of daily nature.
• The exchange rate which exists in spot market is
called spot exchange rate.

50. (B) Forward Market
• The market in which foreign exchange is bought
and sold on a specified future date at a rate agreed
upon today is called forward market.
• The exchange rate that exists in forward market is
known as forward rate.
• Most of the international transactions occur on
forward exchange rate.
• The price at which the foreign exchange will be
sold/ purchased is decided in advance on ‘SPOT’.

51. A forward contract is entered into for two
reasons:
▪ One is to minimize risk of loss due to adverse
change in exchange rate and second to make
a profit.
▪ First is called hedging and the second is
called speculation.

52. Presented by –
Ritvik Tolumbia
CS, CWA, M.Com (ABST), M.A (Eco), B.Ed
Author & Faculty of Commerce