Foreign Exchange rate

Prof. K.Bhargavi
 Foreign exchange rate
Foreign exchange is the name given
to any foreign currency while the
exchange rate is the price of a
countrys currency in terms of
another countrys currency
The exchange rate of the rupee is
market determined and has shown
great volatility in the few years
Fixed and Floating exchange
rate
A fixed exchange rate denotes a nominal
exchange rate that is set firmly by the
monetary authority with respect to a
foreign currency or a basket of foreign
currencies.
By contrast, a floating exchange rate is
determined in foreign exchange markets
depending on demand and supply, and it
generally fluctuates constantly
 Floating and fixed exchange rate
system
In fixed exchange rate, the foreign exchange is
pegged at a certain rate .if there is a disequilibrium
in the BOP giving rise to excess demand or excess
supply of foreign exchange , the central bank of the
country has to buy and sell the required quantities of
foreign exchange to eliminate the excess demand or
supply
Fixed exchange rate system prevailed in the world
under an agreement reached at Bretton Woods in
1944
In 1977 USA decided to float its dollar and switch
over to the flexible exchange rate system resulting in
the collapse of the Bretton Woods system
 Managed Float System in
India
India as most of other countries
including US, UK ,France has adopted
the flexible or floating exchange rate
system
The changes in exports and imports ,
capital outflows and capital inflows
bring about large fluctuations in
foreign exchange rate of rupee
In order to prevent large appreciation
and depreciation of Indian rupee RBI
 Managed Float System in
India
When the Indian rupee is depreciating too
much RBI intervenes and sells dollars
from its reserves of foreign exchange this
increases the supply of dollars in the
market prevents the depreciation of the
rupee
 Some important Exchange Rate
concepts
Real exchange rate measures the
relative price of the two currencies
after adjusting for price levels
prevailing within two countries .
Real exchange between rupee an US
dollar as defined as the rupee price
of a basket of goods in India relative
to a dollar price of the same basket
of goods in the US
RER = NER PUS/PIN = 44x20/200= 4.4
 Determination of exchange
rate
It is in the foreign exchange market that the
exchange rate among different currencies is
determined
Demand for foreign exchange (US dollars )
Demand for dollars by Indians arise due to
the following factors
1. Indian individuals , firms , or government who
import goods from USA into India
2. The Indians travelling and studying in the US
would require dollars to meet there travelling
ad education expenses
 Determination of exchange
rate
Indians who want to invest directly in
building factories sales facilities , shops in
the US
At lower price of dollars , greater
quantities of dollar is demanded for
imports from the USA and at a higher
price of dollar and at a higher price
smaller quantity of dollars is demanded
for imports the demand curve for dollars
is downward sloping
 Determination of exchange
rate
At a higher price of dollar in term of
rupees Indian goods would be
relatively cheaper boosting exports
If the price of dollar in terms of
rupees falls it will encourage imports
 Price of Dollar (Rupees per US Dollar
Y S
D
Excess
66 Supply
R

65.50
R E

64

R Excess
S Demand
D

O Quantity of Dollar X

Determination of Exchange Rate of a US Dollar in terms of Rupees

 Factors Affecting Exchange
Rate
Rate of inflation and exchange rate:
A relatively high rate of inflation in
India discourages exports and
encourages imports.
-The US dollar will appreciate and the
Indian rupee will depreciate.
 S
Y
D S

D
Exchange rate of Dollar

66
R
(Rs.Per dollar)

65
R

S
D
S

O
Q X
Amount of dollars

Effect of a Relatively higher rate of Inflation on the exchange Rate of a countr

 Factors Affecting Exchange
Rate
3. Interest rates and Exchange rate :
A relatively higher interest rate in
India as compared to India would
lead to the depreciation of dollar and
appreciation of the rupee.
 Y S

D
S
Exchange rate of Dollar

E
(Rs.Per dollar)

66
R

65 E
R

S D

O Q
Q X
Amount of dollars

Effect of a Relatively higher rate of Interest in India on the exchange Rate