22

Foreign Exchange

INTRODUCTION

In Chapter 8, we had focused on income determination in a four sector economy. At this stage of our analysis, we are in a position to go a step further and discuss the other important aspects which pertain to an open economy.

Today, all economies are open and dealing in transactions with the rest of the world. They all are involved in the export and import of goods and services. They are also engaged in borrowing and lending in the financial markets of the different countries.

All these different countries have their own currencies, which are generally (the exception being the Euro) legal tender only within the territories of the country. The rupee is acceptable within India where as the dollar is acceptable within the US economy. The problem occurs when one country trades with another. This problem can be solved be fixing the rate of exchange between the different currencies. Here, we discuss the determination of the foreign exchange rate and also the fixed and the flexible exchange rates.

FOREIGN EXCHANGE MARKET

The foreign exchange market is a market where foreign currencies (or foreign exchange) are purchased and sold by individuals, firms, commercial banks and the central banks of the different countries.

 

Types of Foreign Exchange Transactions

Foreign exchange transactions are of two kinds:

 

1. Spot transaction: A spot transaction is one where the seller of the foreign exchange has to deliver the exchange to the buyer on the spot, that is, within two days of the deal.
   1. The spot market is one where there are spot sales and purchases of the foreign exchange.
   2. The spot exchange rate is the rate at which the foreign exchange is bought and sold in the spot market.
2. Forward transaction: A forward transaction is one, which involves an agreement between the buyer and the seller to purchase or sell a fixed amount of currency for a predetermined rate at a specified date in the future. Usually, a forward contract is for a period of three months.

 

The forward exchange market is one where there is a forward sale and purchase of foreign exchange

The forward exchange rate is the rate at which the foreign exchange is bought and sold in the forward exchange market.

Functions of the Foreign Exchange Market

The foreign exchange market performs many functions; some of the important ones are:

1. International transfer of purchasing power between the different countries: In foreign trade, there are two types of transfers of purchasing power, which are as follows:
   1. From one country to another country.
   2. From one currency to another currency.

   These transfers take place through a clearing mechanism. When a firm in a country exports some goods to a firm in another country, the exporting firm acquires a claim on the foreign firm where a the foreign firm is under a debt obligation to the exporting firm. Hence, there arise counter claims which are settled in the foreign exchange market through bills of exchange.

2. Provision of credit for foreign trade: Similar to the domestic trade, credit is essential for the smooth functioning of the foreign trade. There is a considerable time gap involved in the movement of the goods between the exporter and the importer. Hence, there is need for some form of institutional credit to finance the transactions of the goods between the time periods.
3. Hedging risks of foreign exchange: In a situation when the exchange rate fluctuates freely, any forward foreign exchange transaction will be subject to great risks. To avoid such risks, the buyers and sellers of foreign exchange resort to hedging facilities.

Hedging is an attempt at covering the risk involved in a foreign exchange transaction through a forward transaction. The exporters and importers are subject to risks relating to the exchange rate in conducting their business. This risk can be avoided through a forward transaction where they can enter into an agreement regarding the buying and selling of goods at a future date at a contracted rate of exchange. However, where the rates of exchange are stable over long periods of time, hedging is not required.

 

Some Related Concepts

Arbitrage: It is the simultaneous buying and selling of different foreign currencies in the different foreign exchange markets to take advantage of the difference in the prices. An arbitrageur is the person who is engaged in such buying and selling of the foreign currencies.

 

Speculation: It is an activity related to the sale and purchase of foreign exchange in which risk is undertaken to take advantage of the fluctuations in the exchange rate. The speculative buying and selling of the foreign currency depends the speculator’s expectations regarding the future exchange rates.

Speculative attacks: It is a situation, which causes a change in the investors’ perception.

 

Currency board: It is an arrangement under which the central bank of a country holds enough amount of a foreign currency to back, in a fixed ratio, each and every unit of the domestic currency. Thus, under a currency board a country is in a position to commit itself to some strong currency like the dollar. Also whenever the need arises, it should be ready to convert its own currency to the foreign currency.

 

Dollarization: It is a step further than the currency board where a country abandons its domestic currency and adopts a strong foreign currency like the dollar. Thus, the domestic currency is converted into the US dollar.

 

• The foreign exchange market performs many functions which include international transfer of purchasing power between different countries, provision of credit for foreign trade and hedging risks of foreign exchange.

EXCHANGE RATE SYSTEMS

The exchange rate is the rate at which one country’s currency exchanges for another country’s currency. Hence, it reflects the purchasing power of one country’s currency in terms of the purchasing power of another country’s currency. It is actually the price at which the residents of one country conduct trade with the residents of another country.

 

One can distinguish between the nominal exchange rate and the real exchange rate. The nominal exchange rate is the rate at which the currency of one country is traded for the currency of another country. Thus, it signifies the relative price of one currency vis à vis the currency of another country. The real exchange rate is the rate at which the goods of one country are traded for the goods of another country. Hence, the real exchange rate takes into consideration the relative purchasing power of the currency as well. The real exchange rate is also called the terms of trade.

Two nominal exchange rate systems are:

1. Flexible or floating exchange rate: Flexible or floating exchange rate is a system where the exchange rate fluctuates freely in response to the changes in the economic conditions and without any government intervention. Hence, the exchange rate is determined by the market forces
2. Fixed exchange rate: Fixed exchange rate is a system where the exchange rate does not fluctuate in response to the changes in the economic conditions. The exchange rate is maintained through government intervention in the foreign exchange market and also by the central bank through its buying and selling of currencies.

At this stage, a brief history of the exchange rate systems adopted by the different countries is required. When the Second World War ended, there was a need for a new international monetary and exchange rate system which would promote growth of world trade. Thus, at Bretton Woods New Hampshire, in the year 1944, delegates from 44 nations converged. They adopted the fixed exchange rate system in which each country pegged its currency to the dollar and as all currencies were pegged to the dollar, they were pegged to each other also. The International Monetary Fund (IMF) and the World Bank were two new organizations, which emerged from the Bretton Woods conference.

There occurred in succession many crises in the exchange rate. At a meeting held in 1971 at the Smithsonian Institution in Washington, D.C between the finance ministers of the leading countries of the world, the Bretton Woods system was officially dissolved. The dollar was devalued. The major industrial countries of the world adopted the flexible exchange rate in 1973. Thus as of today there are many exchange rate arrangements; while some countries operate under the flexible exchange rates, others operate under the floating exchange rates and there are some for whom the exchange rate systems lie somewhere in between.

• The nominal exchange rate signifies the relative price of one currency vis à vis the currency of another country where as the real exchange rate takes into consideration the relative purchasing power of the currency as well.
• As of today there are many exchange rate arrangements; while some countries operate under the flexible exchange rates, others operate under the floating exchange rates and there are some for whom the exchange rate systems lie somewhere in between.

EXCHANGE RATE DETERMINATION

How the exchange rate is determined will depend on whether the exchange rate system is a flexible or a fixed exchange rate system.

Determination of Exchange Rate in a Flexible or Floating Exchange Rate System

As already mentioned, the exchange rate is the price of one currency in terms of another currency. In a flexible exchange rate system, the exchange rate is determined by the market forces of the demand and supply of foreign exchange. Here we will consider two countries, say India, as the home country and United States, as the foreign country and two currencies, rupee and the dollar.

Demand for Foreign Exchange

Foreign exchange is demanded by the citizens of a country to make payments outside the country. From the point of view of a country, say India, the demand for foreign exchange (say, dollar) arises to make payments for the following items:

1. Imports of commodities.
2. Imports of services, including banking, insurance shipping and tourism.
3. Interest, royalties, payment for technical services and dividend payments on securities in India owned by the foreigners.
4. Expenditures by the government abroad.
5. Remittances by NRIs of capital out of India from realized capital gains.
6. Exports of short-term capital.
7. Exports of long-term capital.
8. Unrequited payments including gifts to foreigners.
9. Gold imports.
10. Payment to foreign universities for education.

In all these items, perhaps the most important item is the imports of commodities since India, like any other developing country, imports commodities like petroleum and machinery which require huge amounts of foreign exchange. In the context of this analysis, as far as India is concerned the demand for foreign exchange is the demand for dollars.

Figure 22.1 depicts the derivation of the demand curve for foreign exchange. Suppose

1. Initially the foreign exchange rate as determined at $1 = Rs. 50 (by autonomous factors). Suppose the price of a basket of goods imported from the United States is $5(or Rs. 250) per unit. Thus to import 100 units of the good, India’s demand for dollars will be $500 or in other words Rs. 25,000.
2. that the value of the rupee depreciates in terms of dollars to $1 = Rs. 60. Since the price of the basket of goods imported from the United States is in terms of dollars (which is not affected), it will remain at $5 (or Rs. 300) per unit. Thus to import 100 units of the good, India’s demand for dollars will also remain unchanged at $500. But in terms of rupees, India will now have to spend Rs. 30,000 on its imports from the United States.

The net effect of the depreciation of the rupee will be an increase in the price of imports and, hence, a decrease in the demand for imports from the United States by India. Hence, there will be a decrease in demand for dollars by India.

In Figure 22.1, an increase in the price of the dollar (or depreciation of the rupee) from $1 = Rs 50 to $1 = Rs. 60 leads to a decrease in the demand for foreign exchange from OF to OF′. Hence, an increase in the exchange rate leads to a decrease in demand for the imports from the US leading to a decrease in demand for the foreign exchange (or dollars). It is obvious from this analysis that the demand curve for foreign exchange (or dollars) will be a downward sloping curve as in Figure 22.1.

The shape and slope of the demand curve for foreign exchange depends on certain factors, which are as follows:

1. The extent of the decrease in the demand for foreign exchange, in response to an increase in the foreign exchange rate, will depend on elasticity of demand for the imported goods. This is because the demand for foreign currency is a derived demand in that it is derived from the demand for the foreign goods and services. For a given depreciation of the rupee,
   1. if the elasticity of demand for the US goods is large then the decrease in demand for the US imports and thus for the dollar will be high. This is the case especially for luxuries and goods for which there exist substitutes.
   2. if the elasticity of demand for the US goods is small then the decrease in demand for the US imports and thus for the dollar will be low. This is the case especially for necessities and raw materials.
   

   Figure 22.1 Demand for Foreign Exchange

2. The existence of import competing industries in the country: If the import competing industries in the country are well developed, then the elasticity of demand for imports will be high. This is because any increase in the price of imports (due to the depreciation of the domestic currency) will be accompanied by an increase in the share of the import competing industries and decrease in the share of the imports.
3. Time is also an important factor here because:
   1. In the short run, a reallocation of factors of production in response to a price change may be a difficult task. Hence, the elasticity of demand for imports may be low.
   2. In the long run, it is possible to reallocate factors of production in response to a price change, and thus change the production pattern accordingly. Hence, the elasticity of demand for imports may be high.

Supply of Foreign Exchange

The supply of foreign exchange to a country arises from the payments made by the foreigners to the residents of the country within a specified time period. From the view point of a country, say India, the supply of foreign exchange (the dollar) arises from payments made for the following items:

1. Exports of commodities.
2. Exports of services including banking, insurance, shipping and tourism.
3. Interest and dividend payments on securities in the US owned by the Indians.
4. Imports of short-term capital.
5. Imports of long-term capital including foreign loans to India.
6. Unrequited receipts including gifts from foreigners.
7. Gold exports.

As far as India is concerned, the supply of foreign exchange is the supply of dollars.

Figure 22.2 depicts the derivation of the supply curve of foreign exchange. Suppose,

1. Initially the foreign exchange rate as determined at $1 = Rs. 50 (by autonomous factors). Suppose the price of a composite of goods exported by India to the US is at Rs. 250 (or $5) per unit. Thus, if India exports 100 units of the composite good the supply of foreign exchange to India will be $500 (25000/50). Since the price of the composite of goods imported from the US is in terms of dollars (which is not affected), it will remain at $5(or Rs. 300) per unit.
   

   Figure 22.2 Supply of Foreign Exchange

2. that the value of the rupee depreciates in terms of dollars to $1 = Rs. 60. Since the price of the composite of goods exported by India to the US is in terms of rupees, it will remain at Rs. 250 (or $4.17) per unit. Thus, if India exports 100 units of the composite good the supply of foreign exchange to India will now be $416.7 (25000/60).

The net effect of the depreciation of the rupee will be a decrease in the price of the exports and hence an increase in the demand for exports to the US from India. Hence, there will be an increase in supply of dollars to India.

In Figure 22.2, an increase in the price of the dollar (or depreciation of the rupee) from $1 = Rs. 50 to 1$ = Rs 60 leads to an increase in the supply of foreign exchange from OF to OF₁. Hence, an increase in the exchange rate leads to an increase in demand for the exports from India to the US leading to an increase in supply of foreign exchange (or dollars). It is obvious from this analysis that the supply curve of foreign exchange (or dollars) will be an upward sloping curve as shown in Figure 22.2.

The shape and slope of the supply curve of foreign exchange will depend on the elasticity of demand for India’s exports to the US. The supply of foreign currency is a derived demand in that it is derived from the demand for the exported goods and services. (India’s exports to the US).

For a given depreciation of the rupee,

1. If the elasticity of demand for India’s exports to the US is greater than unity, then the supply of foreign exchange to India (or dollar) will increase. Hence, the supply curve for foreign exchange is upward sloping as shown in Figure 22.2.
2. If the elasticity of demand for India’s exports to the US is smaller than unity, then the supply of foreign exchange to India (or dollar) will decrease. Hence, the supply curve for foreign exchange will be downward sloping.

Exchange Rate: Equilibrium

The equilibrium rate of exchange is determined at the point at which the demand for foreign exchange equals the supply of foreign exchange. Thus, it is determined by the unregulated forces of the market demand and market supply. Graphically, it is determined at the point of intersection of the demand and the supply curves of foreign exchange.

Figure 22.3 Determination of the Equilibrium Exchange Rate under a Flexible Exchange Rate System

In Figure 22.3, the demand curve for foreign exchange (demand for dollars) and the supply curve of foreign exchange (supply of dollars) intersect at point E. The equilibrium exchange rate is thus at $1 = Rs 50 with the equilibrium amount of foreign exchange at OF.

In such an exchange rate system, the government intervenes as and when required to make sure that the movements in the exchange rate are in order.

Exchange Rate: Disequilibrium

Figure 22.4 depicts the effect of a change in demand on the equilibrium rate of exchange. In the figure,

1. Initially the demand curve for foreign exchange (demand for dollars) is given by the curve DD whereas the supply curve of foreign exchange (supply of dollars) is given by the curve SS.

   The curves DD and SS intersect to determine equilibrium at point E. The equilibrium exchange rate is $1 = Rs 50 with the equilibrium amount of foreign exchange at OF.

   

   Figure 22.4 An Effect of a Change in Demand on the Equilibrium Exchange Rate

2. Suppose the demand curve for foreign exchange shifts outwards to D₁D₁ due to perhaps a change in tastes in India in favour of US goods. The supply curve of foreign exchange (supply of dollars) remains at SS.

At the given exchange rate, there occurs an excess demand for foreign exchange (or dollars) equal to EG. The foreign exchange market will clear only if there is an increase in the exchange rate to $1 = Rs 60. Hence, the new equilibrium occurs at point E₁ where the curves D₁D₁ and SS intersect. The increase in the exchange rate (depreciation of the rupee), on the one hand, causes a decrease in the demand for India’s imports and thus in the demand for dollars and on the other hand, an increase in the demand for India’s exports and thus in the supply of dollars. At the new equilibrium exchange rate of $1 = Rs 60, the equilibrium amount of foreign exchange is at OF₁. Thus, an increase in the demand for imports leads to a depreciation of the domestic currency.

In a flexible exchange rate system, the exchange rate varies with changes in the demand and supply of foreign exchange. But there is always an equilibrium exchange rate at which the demand for foreign exchange equals the supply of foreign exchange creating an external equilibrium.

Fluctuations in the Exchange Rate

There are many factors that can lead to the change in the rate of exchange. One of the most important factors, which influence the exchange rate, is change in the demand and the supply of foreign exchange. However, the demand and the supply of foreign exchange are themselves dependent on the following factors:

1. Trade conditions prevailing in the country: Whenever a country’s exports are greater than its imports, the supply of foreign exchange is greater than the demand for foreign exchange leading to an increase in the value of the domestic currency in terms of the foreign currency. On the other hand, when a country’s exports are smaller than its imports, the supply of foreign exchange is smaller than the demand for foreign exchange leading to a decrease in the value of the domestic currency in terms of the foreign currency.
2. Changes in the interest rate in the domestic country: An increase in the interest rates attracts capital leading to an increase in the supply of foreign exchange. Given the demand for foreign exchange, this will lead to an increase in the value of the domestic currency in terms of the foreign currency. On the contrary, a decrease in the interest rates encourages the export of capital leading to a decrease in the supply of foreign exchange. Given the demand for foreign exchange, this will lead to a decrease in the value of the domestic currency in terms of the foreign currency.
3. Arbitrage operations: As discussed earlier, an arbitrage involves the simultaneous buying and selling of different foreign currencies in the different foreign exchange markets. The purpose of this exercise is to take advantage of the difference in the prices in the two markets. These operations have a singular impact on the foreign exchange market and, in fact, help in ensuring that there exists no major variation in the exchange rates in different currency markets.
4. Stock exchange influences: If the individuals of a country purchase stocks in another country, then there is an increase in demand for foreign currency. Given the supply of foreign currency, this will lead to a decrease in the value of the domestic currency in terms of the foreign currency. If on the other hand, foreigners purchase stocks in the country there is an increase in supply of foreign currency. Given the demand for foreign currency, this will lead to an increase in the value of the domestic currency in terms of the foreign currency. The fall in the value of rupee in the fiscal year 2008–09, thus, could partly be explained by the flight of foreign capital away from the Indian stock markets, which in turn also sent the market indices spiralling down.

Determination of Exchange Rate in a Fixed Exchange Rate System

Many countries have a fixed exchange rate system. In contrast to the flexible exchange rate system where the demand and supply of foreign exchange determine the exchange rate, under a fixed exchange rate system the exchange rate is set by the government in consultation with the other concerned countries.

Figure 22.5 Determination of the Exchange Rate under a Fixed Exchange Rate System

It is not necessary that the exchange rate set by the government is one where the demand for foreign exchange is equal to the supply of foreign exchange. Figure 22.5 depicts the determination of the exchange rate under a fixed exchange rate system. The official exchange rate at e₁ is higher than the basic exchange rate determined by the demand and supply of foreign exchange at e₁. Thus, the exchange rate is overvalued.

The question arises as to what a country should do when its official exchange rate is higher than the basic exchange rate. It has several alternatives to choose from; they are as follows:

1. Change the value of the official exchange rate so that it is equal to or nearer to the basic exchange rate. Thus, in Figure 22.5, the country can lower the exchange rate from e₁ to e.
2. There can be a direct intervention on the part of the government to reduce imports through, say, taxation. Such a policy will decrease the demand for imports shifting the demand curve for foreign exchange raising the basic value of the exchange rate towards the fixed rate.
3. The government of the country could supply or demand its currency in the foreign exchange market. For example, in Figure 22.5, at the official exchange rate the supply of foreign exchange is greater than the demand for foreign exchange by the amount AB. The government could in such a situation buy currency, using official reserve assets like gold.

It is important to note that when the exchange rate of a country is overvalued, then appropriate policy actions will have to be taken because an overvalued exchange rate cannot be sustained for long.

• Foreign exchange is demanded by the citizens of a country to make payments outside the country.
• The net effect of the depreciation of the rupee will be on the one hand an increase in the price of imports and hence a decrease in the demand for imports from the United States by India and, on the other hand, a decrease in the price of the exports and hence an increase in the demand for exports to the United States from India.
• The supply of foreign exchange to a country arises from the payments made for different items by the foreigners to the residents of the country within a specified time period.

FIXED VERSUS FLEXIBLE EXCHANGE RATE

Most major economies now follow the flexible exchange rate system. Even China, where the Yuan was historically pegged to the dollar, lifted the peg finally in the year 2005. The value of the Yuan is now a managed floating exchange rate based on market demand and supply with reference to a basket of international currencies.

It is now the appropriate time for us to evaluate the gains and losses connected with the two major exchange rate systems we have discussed.

Advantages and Disadvantages of the Fixed Exchange Rate System

Advantages of the Fixed Exchange Rate System

1. It eliminates the uncertainties that are associated with international business transactions and, hence, creates a confidence in the foreign currency. A fixed exchange rate removes the uncertainties regarding the exchange rate.
2. In comparison to the floating exchange rate system, the fixed exchange rate system is simpler to implement because the money supply adjusts itself automatically to the required level.
3. It is often able to constrain the inflationary government policies and also acts as a safety device in controlling the import of inflation, which often accompanies a flexible exchange rate system. As a fixed exchange rate shields an economy from the occurrences in the other countries, it is able to prevent any import of inflation.
4. It disciplines a country’s monetary authority and, thus, improves the monetary policy preventing excessive growth in the money supply. Again, this may lead to a lower inflation rate in the long run.
5. It facilitates the movements of capital between countries by providing a stability in the exchange rates and creating a confidence in the foreign currencies.
6. It discourages speculative activity, which is an important feature associated with the flexible exchange rate.

It is important to observe that a fixed exchange rate can be maintained only between countries, which have similar basic economic conditions and similar types of macroeconomic policies.

Disadvantages of the Fixed Exchange Rate System

1. It reduces a country’s ability to apply its monetary policy to deal with recessions. This problem is more acute when the different countries under the fixed exchange rate system aim at different policy goals. In fact there may occur disagreements regarding the goals of monetary policy among the countries under the fixed exchange rate and may ultimately lead to a breakdown of the entire system.
2. As is obvious from the experience of the gold standard and the Bretton Woods systems, a fixed exchange system is rigid and this has unfavourable effects on economies of the countries.

Advantages and Disadvantages of the Flexible Exchange Rate System

Advantages of the Flexible or Market Determined Exchange Rate System

1. It enables countries to formulate their macroeconomic policies independent of the other countries. Hence, a country is not required to sacrifice full employment and other goals to achieve an external equilibrium.
2. It allows monetary and the fiscal policies to attain goals such as employment, stabilizing prices, etc.
3. It provides an automatic and smooth adjustment mechanism for correcting any disequilibrium in the balance of payments of a country concerned through the free market forces of demand and supply.

It seems that empirically the total amount of world trade has increased under the flexible exchange rate system.

Disadvantages of the Flexible Exchange Rate System

1. It increases the uncertainty regarding the future exchange rates, thus, affecting adversely the volume of world trade.
2. It may lead to speculation and may thus disturb the stability in the system.
3. It not only imparts an inflationary bias to the system but is also not able to prevent any import of inflation, which often accompanies a flexible exchange rate system.

The exchange rate system that is ideal differs according to the circumstances. When a group of countries is able to avail huge benefits from an increased trade and is able to coordinate its monetary policies, a fixed exchange rate system is more suitable. However, countries which have their own policy goals relating to, for example, unemployment and inflation, should adopt a flexible exchange rate system.

• A fixed exchange rate can be maintained only between countries, which have similar basic economic conditions and similar types of macroeconomic policies.
• It seems that empirically the total amount of world trade has increased under the flexible exchange rate system.
• Which exchange rate system is ideal differs according to the circumstances.

INTRODUCTION

1. Today, all economies are open and dealing in transactions with the rest of the world.
2. Different countries have their own currencies that are generally (the exception being the Euro) legal tender only within the territories of the respective country. The rupee is acceptable within India where as the dollar is acceptable within the US economy.
3. The problem occurs when one country trades with another. This problem can be solved by fixing the rate of exchange between the different currencies. Here, we discuss the determination of the foreign exchange rate and also the fixed and the flexible exchange rates.

FOREIGN EXCHANGE MARKET

1. In a foreign exchange market, foreign currencies (or foreign exchange) are purchased and sold by individuals, firms, commercial banks and the central banks of the different countries.
2. Two types of foreign exchange transactions are spot transaction and forward transaction.
3. The foreign exchange market performs many functions which include international transfer of purchasing power between different countries, provision of credit for foreign trade and hedging risks of foreign exchange.
4. Hedging is an attempt at covering the risk involved in a foreign exchange transaction through a forward transaction.
5. Arbitrage is the simultaneous buying and selling of different foreign currencies in the different foreign exchange markets to take advantage of the difference in the prices.
6. Speculation is an activity relating to the sale and purchase of foreign exchange in which risk is undertaken to take advantage of the fluctuations in the exchange rate.

EXCHANGE RATE SYSTEMS

1. The exchange rate reflects the purchasing power of one country’s currency in terms of the purchasing power of another country’s currency.
2. The nominal exchange rate is the rate at which the currency of one country is traded for the currency of another country.
3. The real exchange rate is the rate at which the goods of one country are traded for the goods of another country.
4. Two nominal exchange rate systems are flexible or floating exchange rate and fixed exchange rate.
5. Flexible or floating exchange rate is a system where the exchange rate fluctuates freely in response to the changes in the economic conditions and without any government intervention. Hence, the exchange rate is determined by the market forces.
6. Fixed exchange rate is a system where the exchange rate does not fluctuate in response to the changes in the economic conditions.

EXCHANGE RATE DETERMINATION

1. How the exchange rate is determined will depend on whether the exchange rates system is a flexible or a fixed exchange rate system.
2. In a flexible exchange rate system, the equilibrium rate of exchange is determined at the point at which the demand for foreign exchange equals the supply of foreign exchange.
3. Foreign exchange is demanded by the citizens of a country to make payments outside the country.
4. The net effect of the depreciation of the rupee will be an increase in the price of imports and, hence, a decrease in the demand for imports from the United States by India.
5. The supply of foreign exchange is a derived demand in that it is derived from the demand for the exported goods and services.
6. The net effect of the depreciation of the rupee will be a decrease in the price of the exports and, hence, an increase in the demand for exports to the United States from India.
7. Under a fixed exchange rate, the exchange rate is set by the government in consultation with the other concerned countries.

FIXED VERSUS FLEXIBLE EXCHANGE RATE

1. There are gains and losses associated with both the major exchange rate systems, fixed and flexible exchange rate.
2. Advantages of the fixed exchange rate system are that it eliminates the uncertainties that are associated with international business transactions, is simpler to implement, and is often able to constrain the inflationary government policies.
3. Disadvantages of the fixed exchange rate system are that it reduces a country’s ability to apply its monetary policy to deal with recessions and it is rigid.
4. Advantages of the flexible or market determined exchange rate system are: it enables countries to formulate their macroeconomic policies independently of the other countries, it allows monetary and the fiscal policies to attain goals such as employment and stabilizing prices and it provides an automatic and smooth adjustment mechanism for correcting any disequilibrium in the balance of payments.
5. Disadvantages of the flexible exchange rate system are: it increases the uncertainty regarding the future exchange rates. It may lead to speculation and also prevent any import of inflation.
6. When some countries are able to avail huge benefits from an increased trade and are able to coordinate their monetary policies, a fixed exchange rate system is more suitable. However, countries which have their own policy goals relating to, for example, unemployment and inflation, should adopt a flexible exchange rate system.

TRUE OR FALSE QUESTIONS

1. A forward transaction is one where the seller of the foreign exchange has to deliver the exchange to the buyer on the spot, that is, within two days of the deal.
2. The foreign exchange market is a market where foreign currencies are purchased and sold.
3. Currency board is an arrangement where a country abandons its domestic currency and adopts a strong foreign currency like the dollar.
4. The exchange rate is the rate at which one country’s currency exchanges for another country’s currency.
5. The real exchange rate is the rate at which the currency of one country is traded for the currency of another country.

VERY SHORT-ANSWER QUESTIONS

1. What is a foreign exchange market?
2. What do you mean by an arbitrage? Explain
3. How does speculation occur in the foreign exchange market? What is a speculative attack?
4. What type of an arrangement is the currency board?
5. ‘The exchange rate reflects the purchasing power of one country’s currency in terms of the purchasing power of another country’s currency.’ Explain.

SHORT-ANSWER QUESTIONS

1. What are the two types of foreign exchange transactions? Discuss.
2. What is hedging? Explain.

3. (a) What is the exchange rate? Differentiate between the nominal and real exchange rates.

   (b) Which are the two nominal exchange rate systems? Explain.

4. What are the factors that determine the shape and slope of the demand curve for foreign exchange in a flexible exchange rate system?
5. What are the factors that lead to fluctuations in the exchange rate under a flexible exchange rate system? Explain.

LONG-ANSWER QUESTIONS

1. What are the functions performed by the foreign exchange market? Discuss.
2. Which are the two nominal exchange rate systems? Analyse with the help of a brief history of the exchange rate systems adopted by the different countries.
3. Explain the determination of the demand for foreign exchange in a flexible or floating exchange rate system.
4. Analyse the determination of the supply of foreign exchange in a flexible or floating exchange rate system.
5. Discuss the relative advantages and disadvantages of the fixed and flexible exchange rate systems.

TRUE OR FALSE QUESTIONS

1. False. A spot transaction is one where the seller of the foreign exchange has to deliver the exchange to the buyer on the spot, that is, within two days of the deal.
2. True. The foreign exchange market is a market where foreign currencies (or foreign exchange) are purchased and sold by individuals, firms, commercial banks and the central banks of the different countries.
3. False. Dollarization is a step further than the currency board where a country abandons its domestic currency and adopts a strong foreign currency like the dollar. Thus, the domestic currency is converted into the US dollar.
4. True. The exchange rate reflects the purchasing power of one country’s currency in terms of the purchasing power of another country’s currency.
5. False. The nominal exchange rate is the rate at which the currency of one country is traded for the currency of another country.