2. Fixed Exchange and Foreign Exchange Market
Foreign exchange - Any currency other
than the domestic currency
•Foreign Exchange Market in which national
currencies are traded for one another is
known as the foreign exchange market.
3. Foreign Exchange Rate
Foreign Exchange Rate (also called 'Forex Rate') is the
rate at which one currency can be converted into
another currency.
Types of Foreign Exchange Rate
Fixed Exchange
Rate
Flexible
Exchange Rate
Managed Floating
Exchange Rate
4. Fixed Exchange Rate
An exchange rate between the two currencies
fixed at government level is called fixed
exchange rate.
The central bank actively uses its foreign
exchange reserve to maintain the officially
determinate exchange rate.
5. Devaluation and Revaluation of Domestic Currency
Devaluation of domestic currency –Under the fixed exchange
rate system, when government deliberately and purposefully
increases the foreign exchange rate (thereby, making domestic
currency cheaper in term of foreign currency) is called
Devaluation of domestic currency.
•Revaluation of domestic currency –Under the fixed
exchange rate system, when government deliberately and
purposefully decreases foreign the exchange rate (thereby,
making domestic currency costlier in term of foreign
currency) is called Revaluation of domestic currency.
6. Flexible (or Floating) Exchange Rates
An exchange rate determined by the forces of
demand and supply in the foreign exchange market is
flexible or floating exchange rate.
In this system central bank do not intervene in the
foreign exchange market.
A central bank does not maintain any reserve of
foreign currency as the market automatically
adjusts.
It is also know as clean floating.
8. Demand for Foreign Exchange
Imports
Foreign
Transfer
Payments
Investment in
abroad
Tourism in
abroad
Speculation
9. Demand Curve of Foreign Exchange
It is downward sloping because of inverse/negative
relationship between foreign exchange rate and
demand of foreign exchange
Rise in the
price of forex
Increase the
cost of foreign
goods
This reduces
demand for
imports
As a result,
demand for
forex will fall
10. Demand Curve of Foreign Exchange
Y
X
100
o 50
1
2
3
D
D
150
Exchange
Rate
Demand and Supply of
foreign exchange
C
A
B
A rise in the rate of forex leads
upward movement from point
A to point B
A fall in the rate of forex leads
downward movement from
point A to point C
11. Sources of supply of Foreign Exchange
Payment of
Exports
Foreign
Investment
Foreign
Tourism
Transfer
payments
from ROW
Loans &
Grants from
Abroad
12. Supply Curve of Foreign Exchange
It is upward sloping because of direct/positive
relationship between foreign exchange rate and
supply of foreign exchange
Rise in the
price of forex
Domestic goods
become cheaper
This increase
demand for
Exports
As a result, the
supply of forex
will rise
13. Managed Floating Exchange Rates
Exchange rate is determined by the forces of
demand and supply of foreign exchange, but the
Central Bank may intervene to buy or sell foreign
currency to control the exchange rate fluctuations.
Official reserve transactions are, therefore, not equal
to zero. This system is also called 'dirty floating'.
14. Effects of Increase in Demand for Foreign
Exchange
Increase in demand for foreign exchange, the demand curve
shift rightward and it creates excess demand for foreign
currency at the prevailing exchange rate.
As a result, a new foreign exchange rate will be higher than
prevailing exchange rate.
Rise in the price of foreign exchange, say Rs 70$ to Rs 75$
implies “depreciation” of domestic currency.
15. Chain effects of increase in demand
Exchange
Rate
Quantity of foreign exchange rate
0
Y
X
S
Q
P
D
E
E1
P1
Q1
D1
16. Effects of depreciation of domestic
currency on Exports and Imports
Depreciation of home currency implies fall in the purchasing
power of domestic currency in terms of foreign currency.
Depreciation of home currency implies fall in the price of
domestic goods for the foreign buyers.
Depreciation encourages exports as domestic goods become
cheaper for the foreign nationals, i.e ., the international
competitiveness of the goods of the nation gets better
However, depreciation will make imports of foreign goods costlier. So,
imports fall.
Since exports rise and imports fall, therefore, Net Exports (Exports -
Imports) will increase. Therefore, national income is likely to rise.
17. Effects of Increase in Supply for Foreign
Exchange
Increase in supply for foreign exchange, the supply curve shift
rightward and it creates excess demand for foreign currency
at the prevailing exchange rate.
As a result, a new foreign exchange rate will be lower than
prevailing exchange rate.
Fall in the price of foreign exchange, say Rs 75$ to Rs 70$
implies “appreciation” of domestic currency.
18. Chain effects of increase in supply
Exchange
Rate
Quantity of foreign exchange rate
0
Y
X
S
Q
P
D
E
E1
P1
Q1
S1
19. Effects of Appreciation of domestic
currency on Exports and Imports
Appreciation of home currency implies rise in the purchasing
power of domestic currency in terms of foreign currency.
Appreciation makes foreign goods cheaper for the domestic
buyer. Therefore, imports rise.
Appreciation decreases exports since domestic goods
become costlier for the foreign nationals.
Since exports fall and imports rise, therefore, Net Exports
(Exports - Imports) will decrease. Therefore, national income
is likely to fall.
