Foreign Exchange Rate – Comprehensive Study Notes

Concept of Foreign Exchange

• Foreign exchange (FX): Any currency that is NOT the domestic currency.
  • For India, every currency except the rupee (₹) is foreign exchange; in examples, the U.S. dollar ($) is used.
• Foreign-exchange market: The system (not necessarily a physical place) where foreign currencies are bought and sold by individuals, firms, brokers, commercial banks, central banks, etc.

Foreign Exchange Rate (FER)

• Definition: The price of one nation’s currency expressed in units of another nation’s currency.
  • Symbolically, $E_{\text{₹/\$}} = \frac{\text{₹ (required)}}{1\$}$
• Interpreting a quote
  • Example: $1\$ = 62\text{ ₹}$ means 62 rupees must be sacrificed for each dollar.
• FER behaves like any other price: it changes daily according to demand and supply conditions in the FX market.

Currency Depreciation vs. Currency Appreciation

Depreciation (Domestic Currency Weakens)

• Meaning: A fall in the value of domestic currency relative to a foreign currency.
  • $1\$ = 62\text{ ₹} \;\rightarrow\; 1\$ = 64\text{ ₹}$ (more rupees now required for the same dollar).
• Effects
  • Domestic exports become cheaper to foreigners ⇒ export volume rises.
  • Imports become costlier for domestic residents ⇒ import volume falls.
  • Often considered "beneficial" for net-exporting sectors but raises imported-input costs.

Appreciation (Domestic Currency Strengthens)

• Meaning: A rise in the value of domestic currency relative to a foreign currency.
  • $1\$ = 62\text{ ₹} \;\rightarrow\; 1\$ = 60\text{ ₹}$ (fewer rupees needed per dollar).
• Effects
  • Imports become cheaper ⇒ import volume rises.
  • Exports become dearer to foreigners ⇒ export volume falls.

Exchange-Rate Regimes

1. Fixed (Pegged or Parity) System

• Government/central bank sets and maintains an announced parity value.
• Peg can be to:
  • A commodity standard (gold/silver).
  • Another currency (\$ or ¥ etc.)—called pegging.
• Main objective: Stability in trade and capital flows.
• Adjustment tools
  • Devaluation: Government‐announced ↓ in parity value.
  • Revaluation: Government‐announced ↑ in parity value.

2. Flexible (Floating) System

• FER determined solely by market demand & supply.
• Currency with higher demand appreciates; excess supply leads to depreciation.
• Value allowed to fluctuate freely.

3. Managed Float (Dirty Float)

• Hybrid of fixed & flexible.
• Market forces set the rate most of the time, but the central bank intervenes during extreme swings to keep E within a target band.
• Requires FX reserves (RBI acts as custodian of India’s reserves).

Demand for Foreign Exchange (\$)

• Sources & motives
  1. Payment for imports of goods & services.
  2. Outbound tourism & travel expenditure.
  3. Purchase of foreign assets (real estate, equities, bonds).
  4. Unilateral transfers (remittances, gifts).
  5. Speculation: Buy cheap foreign currency expecting future appreciation.
• Why demand rises
  • Fall in price of foreign currency ⇒ imports & tourism surge ⇒ higher demand.
  • Lower price encourages speculative buying.

Demand Curve Characteristics

• Downward-sloping (inverse relation between E and quantity demanded $Q_d$).
• Graph intuition: When $E<em>{\text{₹/\$}}$ falls from $OR</em>1$ to $OR<em>2$, $Q</em>d$ rises from $OQ<em>1$ to $OQ</em>2$.

Supply of Foreign Exchange (\$)

• Sources & motives
  1. Exports of domestic goods & services (foreigners pay in $).
  2. Foreign Direct Investment (FDI)/Portfolio flows: Foreigners invest domestically in their own currency.
  3. Inbound tourism revenues.
  4. Gifts/remittances from abroad.
  5. Speculation: Holders sell $ when it becomes dearer.
• Why supply rises
  • Rise in price of foreign currency ⇒ domestic goods look cheaper abroad ⇒ export surge ⇒ more $ supplied.
  • Higher price triggers speculative sales.

Supply Curve Characteristics

• Upward-sloping (positive relation between E and quantity supplied $Q_s$).
• Graph intuition: When $E<em>{\text{₹/\$}}$ rises from $OR</em>1$ to $OR<em>2$, $Q</em>s$ rises from $OQ<em>1$ to $OQ</em>2$.

Equilibrium Exchange Rate Determination

• Equilibrium occurs where $Q<em>d = Q</em>s$ (point $E$ on intersecting curves).
  • Exchange rate at equilibrium = $E^<em>$ (say $OR$), quantity traded = $Q^</em>$ (say $OQ$).
• Disequilibrium cases
  • Excess Demand (\$ shortage): $Q<em>d > Q</em>s$ ⇒ upward pressure on E ⇒ domestic currency depreciates until equilibrium is restored.
  • Excess Supply (\$ surplus): $Q<em>s > Q</em>d$ ⇒ downward pressure on E ⇒ domestic currency appreciates.

Shifts & Comparative-Statics Analysis

1. Shift in Demand

• Increase in demand (DD → D’D’)
  • New equilibrium $E<em>1 > E^<em>$, Q1 > Q^ ⇒ domestic currency depreciates.
• Decrease in demand (DD → D’’D’’)
  • New equilibrium $E<em>1 < E^<em>$, $Q</em>1 < Q^</em>$ ⇒ domestic currency appreciates.

2. Shift in Supply

• Increase in supply (SS → S’S’)
  • New equilibrium $E<em>1 < E^<em>$, Q1 > Q^ ⇒ domestic currency appreciates.
• Decrease in supply (SS → S’’S’’)
  • New equilibrium $E<em>1 > E^<em>$, $Q</em>1 < Q^</em>$ ⇒ domestic currency depreciates.

Foreign Exchange Market: Structure & Functions

• Nature: Network of banks, dealers, brokers, MNC treasuries, central banks conducting FX transactions via electronic platforms/telecommunications.
• Key Functions
  1. Transfer: Moves purchasing power across borders using payment instruments (bills of exchange, bank drafts, SWIFT transfers).
  2. Credit: Grants short-term credit (typically 90-day bills) to finance international trade.
  3. Hedging: Offers instruments/contracts to insulate traders from FER volatility; locking future transactions at today’s agreed rate.

Market Segments

• Spot Market: Immediate delivery (usually T+2 settlement); ruling price is the spot rate.
• Forward Market: Contract today for delivery/settlement on a specified future date at the forward rate; primary vehicle for hedging against adverse FER movements.

Practical / Policy Implications & Connections

• Depreciation can correct trade deficits but may fuel imported inflation.
• Fixed regimes require ample reserves; speculative attacks can force abrupt devaluations.
• Managed float allows monetary autonomy while dampening volatility; RBI uses reserves & instruments (e.g.
  • Spot intervention,
  • Forward swaps,
  • Sterilisation) to smooth extremes.
• Demand–supply framework underpins curriculum topics such as Balance of Payments (BoP), macroeconomic policy trilemma, and purchasing-power parity theories.

Quick Reference Equations & Figures

• Price quotation: $E_{\text{domestic/foreign}} = \frac{\text{units of domestic currency}}{1\text{ unit foreign}}$.
• Depreciation % change: $\%\Delta E = \frac{E<em>{\text{new}} - E</em>{\text{old}}}{E_{\text{old}}} \times 100$ (positive for depreciation).
• Demand elasticity logic: $E \uparrow \Rightarrow Q<em>d \downarrow$; Supply elasticity: $E \uparrow \Rightarrow Q</em>s \uparrow$.
• Equilibrium condition: $Q<em>d(E^<em>) = Q</em>s(E^</em>)$.