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Foreign Exchange Rate And Its Economic Effects | Detailed Information

EXCHANGE RATE AND ITS ECONOMIC EFFECTS

INTRODUCTION

Each day we get fascinating news about currency which fuel our curiosity, such as Rupee gains 12 paise against US Dollar Spot/Forward Rates plummet, Rupee down, Euro holds steady, Pound strengthens etc. Ever wondered what these and other jargons mean? We shall try to understand a few fundamentals related 
to currency transactions.

The demand for supply of domestic currency. It is not domestic currency alone that we need. Households, businesses and governments in India, for example, buy different types of goods and services produced in other countries. Similarly, residents in India. Foreign investors, businesses, and government invest in our country, just as our nationals invest in other countries. In the same way, lending, and borrowing also take place internationally. These and similar other transactions give rise to an international dimension of money, which involves exchange of one currency for another. Obviously, this entails market transactions involving determination of price of one currency in terms of another.

THE EXCHANGE RATE

The term Foreign Exchange refers to money denominated in a currency other than the domestic currency. Similar to any other commodity, foreign exchange has a price. The exchange rate, also known as a foreign exchange (FX) rate, is the price of one currency expressed in terms of units of one currency that exchanges for a unit of another. In other words, exchange rate is the rate at which the currency of one country exchanges for the currency of another country. It is the minimum number of units of one country's  currency required to purchase one unit of the other countries currency. It is important to note that the value of a currency is relative as it is always given in terms of another currency.

There are two ways to express nominal exchange rate between two currencies (e.g.) the US $ and Indian Rupee) namely direct quote and indirect quote. The direct form of quotation is also known as European Currency Quotation whereas indirect form is called as American Currency Quotation. 

A direct quote is the number of crew of a local currency exchangeable for one unit of a foreign currency. The price of 1 dollar may be quoted in terms of how much rupees it takes to buy one dollar. 

For example, rs 66/ US$ means that an amount of Rs 66 is needed to buy one US dollar of rs 66 will be received while selling one US dollar.

 An indirect quote is the number of crew of a foreign currency exchangeable for one unit of local currency; 

For example: $ 0.0151 per rupee. A quotation in direct form can easily be converted into a quotation in indirect form and  a quotation in indirect form can easily be converted into a quotation in direct form. This is done by taking the reciprocal of the given rate.

An exchange rate has two currency features a base currency and a counter currency.

THE EXCHANGE RATE REGIMES 

An exchange rate regime in the system by which a country manages its currency in a respect to foreign currencies. It refers to the method by which the value of the domestic currency in terms of foreign currencies is determined. There are two types of exchange rate regimes:

  1. floating exchange rate regime (also called a flexible exchange rate), and
  2. fixed exchange rate regime
Under floating exchange rate regime, the equilibrium value of the exchange rate of a country's currenc is marker-determined i.e the demand for and supply of currency relative to other currencies determine the exchange rate. There is no predetermined target rates and the exchange rates are likely to change at every moment in time depending on the changing demand for and supply currency in the market. There is no interference on the part of the government or the central bank of the country in the determination of exchange rate. Any intervention by the central banks in the foreign exchange market (through purchases or sales of foreign currency in exchange for local currency) is intended for only moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than for establishing a particular level for it.

A fixed exchange rate, also referred to as pegged exchanged rate, is an exchange rate regime under which a country's central bank and/or government announces or decrees what its currency will we worth in terms of either another country's currency or a basket of currencies or another measure of value, such as gold. For example: a certain amount of rupees per dollar. (When a government intervenes in the foreign exchange market then the exchange rate of its currency is different from what the market would have produced, it is known to have established a "peg" for its currency). In order to sustain a fixed exchange rate, it is not enough that a company pronounces a fixed parity: it must also make concentrated efforts to defend that parity by being willing to buy (or sell) foreign reserves whenever the market demand for foreign currency is lesser (or greater) than the supply of foreign currency. In other words, in order to maintain the exchange rate at the predetermined level, the central bank intervenes in the foreign exchange market.
A fixed exchange rate avoids currency fluctuations and eliminates exchange rate risks and transaction costs that can impede international flow of trade and investments. A fixed exchange rate can thus greatly enhance international trade and investment.

CHANGES IN EXCHANGE RATES

Changes in exchange rates portray depreciation or appreciation of one currency. The terms, rupee 'currency appreciation' and 'currency depreciation' describes the movement of the exchange rate. Currency appreciates when its value rises with respect to the value of another currency or a basket of other currencies. On the contrary, currency depreciates when its value falls with respect to the value of another currency or a basket of other currencies. 

Under a floating rate system, if for any reason, the demand curve for foreign currency shifts to the right representing increased demand for foreign currency, and supply curve remains unchanged, than the exchange value of foreign currency rises and the domestic currency depreciates in value.


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