1. Identify the terms:
(a) These rates fluctuate depending on demand and supply of currencies in foreign exchange markets, in
principle without interference by governments.
Answers
Answer = Foreign Exchange Rate is the amount of domestic currency that must be paid in order to get a unit of foreign currency. According to Purchasing Power Parity theory, the foreign exchange rate is determined by the relative purchasing powers of the two currencies.
Example: If a Mac Donald Burger costs $20 in the USA and Re 100 in India, then the exchange rate between India and the USA will be (100/20=5), 1 $ = 5 Re.
Forces Behind Exchange Rate Determination
Foreign Exchange is a price of one country currency in relation to other country currency, which like the price of any other commodity is determined by the demand and supply factors. The demand and supply of the foreign exchange rate come from the residents of the respective countries.
Demand for Foreign Exchange (Foreign Money goes out) Supply of Foreign Exchange (Foreign Money Comes in)
Foreign Currency is needed to carry out transactions in foreign countries or for the purchase of foreign goods and services (IMPORTS). The source of foreign currency available to the domestic country are foreigners purchasing our goods and services (Exports).
Foreign currency is needed to invest in foreign country assets/shares/bonds etc. Foreigners investing in Indian Stock markets, Assets, Bonds etc. (FPIs and FDIs)
Foreign currency is needed to make transfer payments. Example: Indian Parents sending Money to his/her son/daughter studying in the USA. Transfer payments. Example: Indian working in the USA, sending money to his/her old aged parents.
Indians holding money in overseas Banks Foreigners holding assets in Indian Banks.
Indians Travelling abroad for Tourism Purpose. Foreigners travelling to India.
The DD curve represents the demand for foreign exchange by India. The SS curve represents the supply of foreign exchange to India.
The point where both DD and SS curves intersect is the point of equilibrium. At this point demand for foreign exchange is exactly equal to the supply of foreign exchange.
At equilibrium point E0, the exchange rate is 1 $ equal to 5 Re.
In normal day to day functioning of markets, the exchange rate may fluctuate. If at any point in time, the exchange rate is at E1, then the demand for foreign exchange falls short of supply of foreign exchange, as a result at this point Indians are demanding less foreign currency due to which Re will appreciate vis-à-vis foreign currency. The appreciation mainly occurs due to a favourable balance of payment situation (Surplus).
By the same token at point E2, demand for foreign exchange is greater than the supply of foreign exchange, at this point Indians are demanding excess foreign exchange than what the foreigners are willing to supply, as a result, at E2 Re will depreciate vis-à-vis foreign currency. The depreciation mainly occurs due to the unfavourable balance of payments situation(Deficits).
Types of Exchange Rate Regimes
Fixed Exchange Rate versus Floating Exchange Rate
Fixed Exchange Rate Floating Exchange Rate
Under this system, there is complete government intervention in the foreign exchange markets. Under this system, the market is allowed to determine the value of exchange rate freely.
The government or central bank determines the official exchange rate by linking exchange rate to the price of gold or major currencies like US dollar. The exchange rate is determined by the forces of demand and supply.
If due to any reason, the exchange rate fluctuates, government intervenes and make sure that equilibrium pre-determined level is maintained. If due to any reason exchange rate fluctuates, the government never intervenes and allows the market to function and determine the true value of exchange rate.
The only merit of fixed exchange rate system is that it assures the stability of exchange rate. It prevents both currency appreciation and depreciation. The only demerit of floating exchange rate system is that exchange rate fluctuates a lot on day to day basis.
The many disadvantages of such a system are: It puts a heavy burden on governments to maintain exchange rate. This especially happens during the time of deficits, as the governments need to infuse a lot of money to maintain exchange rate.
The foreign investors avoid investing in such countries as they fear to lose their investments because they believe that exchange rate does not reflect the true value of the economy.
The advantages of such a system are: the exchange rate is determined in well-functioning foreign exchange markets with no government interference.
The exchange rate reflects the true value of the domestic currency which helps in establishing the trust among foreign investor.
A country can easily access funds/ loans from IMF and other international institutions if the exchange rate is market determined.