Foreign exchange refers to the reserve of foreign currencies, e.g. currency of US and UK are the foreign exchange for India.
FOREIGN EXCHANGE RATE
The price at which one currency is exchanged for another is called the rate of exchange. In other words, the rate of exchange is the price of one currency stated in terms of another currency.
- If one US dollar exchanges for 60 Indian rupees, then the rate of exchange is $1 = ₹60 or ₹1 = 1/60 .
- If one British Pound can be obtained by paying ₹90, the exchange rate is 1 British Pound = 90 Indian Rupees (£1 = ₹90).
“The rate of exchange measures the number of units of one currency which will exchange in the foreign exchange market for another.”
Economics call it external value of the currency.
Exchange rate can be expressed in two ways:
- In units of domestic currency:
Under it, the number of units of domestic currency for a unit of foreign currency is expressed:
Example: 1 Pound = ₹90
- In units of foreign currency:
Under it, the number of units of a foreign currency for a unit of domestic currency is expressed:
Example: ₹1 = 1/90 Pound = 0.11 Pound.
TYPES OF EXCHANGE RATE
Exchange rate systems are mainly of 3 types:
- Fixed Exchange Rate System
- Flexible Exchange Rate System
- Managed Floating System
FIXED EXCHANGE RATE SYSTEM
Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed by the government. Such a rate does not vary with changes in demand and supply of foreign currency. Only government has power to change it.
There were 2 systems of fixed exchange rate:
- Gold Standard System
- Bretton Woods of Exchange Rate system
- Gold Standard System
Under this system, exchange rate is officially declared and it is fixed. Only a very small change from this fixed value is possible. A typical fixed exchange rate system was associated with the Gold Standard Systems of 1880-1914. Under the Gold Standard system, each currency value was defined in terms of gold and hence, the exchange rate was fixed according to the gold value of currencies that have to be exchanged. This was referred to as mint part value of exchange.
Example: If one British pound is exchangeable for 125 grains of fine gold and the US dollar ($) for 25 grains, then one pound is equal to 125/25 = 5 US dollars. So the price is fixed at £1 = $5. This was referred to as mint part rate of exchange.
- Bretton Woods System
Under Bretton Woods System (named after Bretton Woods – a place in USA where UN nations held a conference in 1944), gold was replaced by US dollar. Under this system, all currencies were pegged or linked to US dollar at a fixed exchange rate. Under this system USA guaranteed the convertibility of dollar into gold at $ 35 per ounce of Gold. The Central Bank of each IMF member was committed to convert its currency into dollar at a fixed price. An adjustment in the in the parity was possible only through a direction from the International Monetary Fund. That is why it was called Adjustable Peg System of Exchange Rate. Gold continued to be the ultimate unit of parity between any two currencies.
Merits of Fixed Exchange Rate System
- It ensures stability in exchange rate. Due to certainty, it promotes foreign trade.
- It promotes capital movements because it does not involve any uncertainties about exchange rate that may cause capital loss.
- It prevents capital outflow.
- It stops speculation in foreign exchange market.
- It helps the government to check inflation.
Demerits of Fixed Exchange Rate System
- It requires high reserves of gold. Huge gold reserves hinder movement of capital or foreign
- It discourages the objective of having free markets.
- It may result in undervaluation or overvaluation of currency.
- It may not be the market equilibrium.
- An economy following this system, may find it difficult to combat either depression or recession.
Overvaluation of currency
It is a situation in which the exchange rate of a currency exceeds what the open market is willing to pay.
Undervaluation of currency
It is a situation in which the value of currency is lower than what is expected in the exchange market.
Fixed exchange Rate system has been discontinued because of the many demerits of this system, by all leading economies of the world, including India.
FLEXIBLE EXCHANGE RATE SYSTEM
In a system of flexible exchange rates (also known as floating exchange rates) the exchange rate is determined freely by the market forces of demand and supply. There is no intervention by the central banks. Hence, there are no official reserve transactions. A foreign exchange market like other competitive markets, leads to an equilibrium exchange rate at which quantity demanded equals quantity supplied of foreign exchange.
Since 1977, international Monetary Fund has also agreed for the operation of flexible exchange rate.
DEMAND FOR FOREIGN EXCHANGE
- Importers: Importers (firms, households or government) of a country purchase foreign goods and services. They would then need to pay in foreign currencies. The largest demand for foreign exchange comes from the importers.
- Sending Remittances Abroad: Foreign exchange is also demanded for sending remittances (gifts and other transfer incomes) abroad.
- Purchase of Financial Assets Abroad: Foreign exchange is also demanded by those who wish to purchase financial assets (i.e., shares, debentures of a foreign company) abroad.
- Speculators: Speculators are the persons who buy and sell foreign currencies with the intention of making profits. They do not buy and sell foreign currency for any economic consideration such as import or export of goods and services. Their consideration is purely speculation. For example, if people expect that the price of US dollar in money terms would increase in future, they will buy dollars today. They will do so in the expectation of making profits when dollar becomes expensive.