1) The exchange rate is the rate at which one currency is traded for another. Exchange markets determine currency values based on supply and demand. 2) Countries trade goods and currencies through exchange markets. Equilibrium exchange rates are reached through supply and demand of each currency. 3) Factors like exports, imports, inflation rates, interest rates, and speculation can cause exchange rates to appreciate or depreciate. Appreciation increases a currency's purchasing power while depreciation decreases it.

1. Exchange Rate
4.1 Freely Floating exchange Rate

2. Introductory Basic terms
• Exchange Rate = Rate at which one currency is
traded with other currency
• Foreign Exchange = Currency of any other
country
• Transactions = Exchange of goods in
international market
• Exchange market = A market where demand
for and supply of currency set the value of
currency

3. Why we need foreign exchange?
Country 1 [Rs]
a) Supply of goods (Rs)
b) Demand for goods
i. Produced in [Rs]
ii. Produced in [$]
(Imported)
Country 2 [$]
a) Supply of goods ($)
b) Demand for goods
i. Produced in [$]
ii. Produced in [Rs]
(imported)

4. Equilibrium exchange Rate
In
Freely floating market
• Depends on the demand and supply of
respective currencies
• Assuming two countries domestic and foreign
• Currencies Domestic Rs and Foreign $
• Demand for Rs <=> Supply of dollar [Foreign]
• Demand for dollars <=> supply of Rs
[domestic]

5. Market for $ Market for dollars
• Demand for dollars, downward
sloping curve <= from Indian
residents [imports, investment in
US, tourist ]
• Down ward slope indicates: if
price of $ rises (.80) => fall in
demand and fall in price of $ (.50)
=> rise in demand for $
• Supply of dollars, upward sloping
curve <= US residents [selling
dollar for Rs, Investment, like
more holidays in India ]
• Upward slope indicate: price of
dollar rise (.80) => rise in supply to
take benefit and less for (.50Rs)
Quantity of $
$priceinRs
.80
.67
.50
Demand $
Supply $
Excess
Demand $
Excess Supply $

6. Market for $ Market for dollars
• Demand for Rs, downward
sloping curve <= from US
residents [imports, investment
in India, tourist ]
• Down ward slope indicates: if
price of Rs rises ( $ 2.0) => fall in
demand and fall in price of Rs
($1.25) => rise in demand for Rs
• Supply of Rs, upward sloping
curve <= Indian residents
[selling Rs for $, Investment,
like more holidays in US ]
• Upward slope indicate: Price of
Rs rise ($2) => rise in supply to
take benefit and less for ($1.25)
Quantity of Rs
Rs.pricein$
2.0
1.5
1.25
Demand Rs
Supply Rs
Excess Demand $
Excess Supply $

7. Demand for $ Increase
Market for dollars
• Value of $ increase (Appreciate)
i. Demand for $ increases
ii. Supply of & decreases
• Assume equilibrium A, Demand
for US goods increases =>
increase in demand for $ => D1
$ shifts to D2 $
• New higher price 1$ = .90
dollars, the price of dollars has
increased in terms of Rs=>
Appreciation
Quantity of $
$priceinRs
.90
.67
D1 for $
Supply $
Exchange Rate: Appreciation
D1 for $
A
C
B

8. Supply for Rs Increase: Rs
depreciate Market for dollars
• Value of $ increase (Appreciate)
i. Demand for $ decreases
ii. Supply of $ increase
• Assume increase in supply of S1
Rs to S2 Rs, resulting in new
equilibrium $ 1.11 from $ 1.5.
• New equilibrium
Rs .90 = 1 dollar (Appreciate)
I dollar = 1.11 Rs (Deppreciate)
Quantity of Rs
Rspricein$
1.11
1.5
D1 for Rs
S1 of Rs
Exchange Rate: Rs Depreciate
S2 for Rs
D
F
E

9. Causes of change in exchange rate
Use of Foreign exchange:
For stability
Use to buy or sell
currency
a) Purchase $ to app Rs
b) Selling $ : depreciate
Rs
Speculation
Purchase and
sales
of currency to make
short term benefits
Foreign demand for Exports
Domestic demand for import
Relative inflation rate
Relative rate of interest
Investment from/to abroad
Changes in income
Speculation
Use of foreign reserves
Investment
a) FDI
b)Financial
Rise: app
Fall: dep
Relative interest
rate:
Rise: Ap
Fall: Dep
Relative Inflation
rate:
•Rise: Ap
•Fall: Dep
Domestic Demand
for imports:
• Rise in Demand for
imports =>
Depreciation
•Fall in demand for
exports= >
Appreciation
Foreign Demand for
Exports
• Rise in demand =>
Appreciation
•Fall in demand =>
Depreciation

10. Evaluating effects of exchange rate
• Appreciations of
currency = > increases
the purchasing power to
buy more or other
currencies
• Similarly more of other
currency needed to buy
appreciate currency
• Depreciation holds a
reverse effect
Cost push
• Depreciation =>
imports expensive =>
increases firms
production cost =>
increases in prices
• Appreciation =>
reduces firms prod cost
=> reduces inflationary
pressure
Demand Pull
• Change in Exchange
rate => Changes in AD
• Depreciation =>
Exports cheaper =>
increases exports and
reduces imports
• Effect depends on
economic phase as in
recession no inflation
1. On cost push inflation
2. On Demand pull inflation
3. On employment
4. On economic growth
5. On the current account
Balance
6. On foreign debt
Employment
• Depreciation =>
increases AD =>
increases job
opportunities
• If economy already at
full employment =>
reduces natural
unemployment
Economic Growth
• Depreciations =>
increases exports =>
increases AD =>
Economic growth
• Appreciation will lead
to reverse effect
BoP current account
• Depreciation =>
increases exports =>
increase in foreign
exchange => BoP on
current account will
improves
• Appreciation reverse
effect
Foreign Debt
• Depreciation => fall in
value of currency = >
increases debt
• suppose foreign debt
$ 1 dollar when (1 dollar
= 1 Euro) =>
depreciation make 1 $ =
Euro 1.5
•Making debt 1.5 euros