Foreign exchange involves the conversion of one country's currency into another's. It occurs in foreign exchange markets where currencies are bought and sold. The exchange rate is the rate at which one currency can be exchanged for another. There are three main types of exchange rate systems: fixed rates which maintain stability but lack flexibility, floating rates which are determined by market forces, and managed rates which permit some government influence. The purchasing power parity theory holds that exchange rates will adjust over the long run to equalize the purchasing power of currencies, while the balance of payments theory cites a country's trade flows and financial account as determining exchange rate supply and demand.

1. ECONOMICS
Foreign Exchange
Short revision series

2. FOREIGN EXCHANGE
 Popularly referred to as FOREX
 The conversion of one country’s currency
into that of another.
 It is the minimum number of units of one
country’s currency required to purchase one
unit of the other country’s currency.

3. Foreign exchange markets
 Place where foreign monies are bought and
sold
 It involves the buying of one currency and
selling of another simultaneously
 Exchange rates are determined here
 Has no geographical boundaries

4. Foreign exchange rate
 It is the rate at which one currency will be
exchanged for another in foreign exchange.
 It is also regarded as the value of one
country’s currency in terms of another
currency.
 Types
 There are 3 basic types:
1. Fixed rate
2. Floating rate
3. Managed rate

5. Fixed exchange rate
 It is the system of following a fixed rate for
converting currencies.
 In this system, the government intervenes in
the currency market in order to keep the
exchange rate close to a fixed target
 It does not allow major fluctuations from the
central rate.

6. Advantages/disadvantages of fixed
exchange rate.
 Advantages
 It provides stability of exchange rate
 Fixed rates provide greater certainty for
exporters and importers
 Disadvantages
 Too rigid
 Need large reserves to defend the fixed rate
and keep it from falling.
 May cause destabilizing speculations

7. Floating/Flexible exchange rate
 Under the flexible exchange rate system, the
rate of exchange is allowed to vary to suitthe
economic policies of the government.
 Flexible exchange rates are exchange rates
which fluctuate according to market forces.
 The value of the currency is determined
solely by forces of demand and supply in the
exchange market.

8. Advantages/disadvantages of
floating exchange rate
 Advanatages
1. Automatic adjustment for countries with a
large balance of payment deficit
2. Flexibility in determining interest rates
3. Allow countries to maintain independent
economic policies
4. Permit a smooth adjustment to external
shocks
5. Dont need to maintain large reserves to
maintain rates.

9.  Disadvantages
1. Flexible exchange rates are highly unstable
so that flows of foreign trade and
investment may be discouraged.
2. They can cause inflation.

10. Managed exchange rate
 Managed exchange rate systems permit the
government to place some influence on an
exchange rate that would otherwise be freely
floating.
 The exchange rate has attributes of both
systems
 Through such official interventions it is
possible to manage both fixed and floating
exchange rates.

11. Theories of exchange rate
1. Purchasing Power Parity Theory (PPP
theory)
2. The balance of Payment Theory

12. Purchasing Power Parity Theory
(PPP theory)
 Most widely accepted theory
 According to PPP theory, when exchange
rates are of a fluctuating nature, the rate of
exchange between two currencies in the long
run will be fixedby their respective purchsing
powers in their own nations
 i.e the price of a good that is charged in one
country should be equal to the one charged
for the same good in another country, being
exchanged at the current rate.

13.  This rule is also known as the law of one
price.
 It is an economic theory that estimates the
amount of adjustment needed on the
exchange rate between countries in order for
the exchange to be equivalent to each
currency’s purchasing power.

14. The balance of payment theory
 The balance of payments approach is another
method that explains what the factors are that
determine the supply and demand curves of a
country’s currency.
 As it is known from macroeconomics, the
balance of payments is a method of recording all
the international monetary transactions of a
country during a specific period of time.
 The transactions recorded are divided into four
categories: the current account transactions, the
capital account transactions, financial account
and the central bank transaction.

15. CURRENT ACCOUNT
export and import of goods &services
CAPITAL ACCOUNT
Capital transfers
FINANCIAL TRANSFERS
Foreign direct investment
Portfolio investment
RESERVEBANK TRANSACTIONS

16. DETERMINANTS OF FOREIGN
EXCHANGE RATE
1. Interest Rate
Whenever there is an increase interest rates in
domestic market there will be increase
investment funds causing a decrease in
demand for foreign currency and an increase
in supply of foreign currency.
2. Inflation Rate
when inflation increases there will be less
demand for local goods (decreased supply of
foreign currency) and more demand for foreign
goods (increased demand for foreign currency).

17. 3. Government budget deficit or surplus
The market usually react negatively to widening
govt. budget deficits and positively to narrowing
budget deficits. This will result in change in the
value of countries currency.
4. Political conditions
Internal, regional and international political
conditions and events can have a profound
effect on currency market

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