Economics Ch - 11 Class 12th (Foreign Exchange Rate) Part - 1
Ch - 11 (Foreign Exchange Rate) Part - 1
Foreign Exchange Rate - It refers to that rate at which one currency is exchange for other currency.
At the individual level, there is inverse relationship between Price and Demand. It means lesser the price, greater the demand or vice - versa.
At the market level, demand is related to the price. More demand leads to more Price and Less demand leads to less price.
At the individual level, there is positive relationship between Price and Supply less price leads to less supply and more price leads to more supply.
At the market level, there is inverse relationship between the price and supply. It means more supply leads to less price and vice - versa.
Exchange Rate is broadly Classified as :-
1.) Flexible exchange rate.
2.) Fixed exchange rate.
1.) Flexible Exchange Rate :-
Flexible exchange rate or floating rate of exchange is that rate which is determined by the Supply - Demand forces in the Foreign exchange rate.
It is also called Free exchange rate as it is determined by the free play of Supply and Demand forces in the International money market.
The exchange rate at which demand for foreign currency is equal to its supply is called Equilibrium Rate of Exchange.
Determination of Flexible Exchange Rate :-
Demand and Supply of Foreign exchange are the two basic determinants of flexible exchange rate.
Demand for Foreign exchange - Other things remains constant, demand for foreign exchange is inversely related to the price of foreign exchange.
Equilibrium rate of exchange or rate of exchange occurs when supply of foreign exchange is equal to the demand for foreign exchange.
~ X-axis indicate Supply and Demand of foreign currency.
~ Y-axis indicates exchange rate.
~ S indicates the supply of foreign currency.
~ D indicates the demand of foreign currency.
~ Point E indicates the equilibrium rate of exchange.
Impact of Change in Demand and Supply:
1.) Impact of increase in demand for a foreign currency -
Assumption - (1) OR: 1 US $ = 60 Rs
(2) OR1 : 1 US $ = 70 Rs
Demand curve shifts from D to D1. This causes a rise in exchange rate of OR to OR1. Now one US $ is available for 70 Rs instead of 60 Rs.
Thus other things remaining constant, increase in demand for foreign currency leads to a rise in demand in foreign exchange rate, This is described as a state of currency depreciation.
Currency depreciation refers to a situation when domestic currency depreciates or losses its value in relation to a foreign currency.
2.) Impact of decrease in demand for a foreign currency -
Assumption : (1) OR : 1 US $ = 60 Rs
(2) OR1 : 1 US$ = 50 Rs
Demand curve shift from D to D1. This cause a fall in the equilibrium exchange rate from OR to OR1. Now One US $ is is available for 50 Rs instead of 60 Rs.
Thus, other things remaining constant,decrease in demand for foreign currency leads to fall in exchange rate. This is described as a situation of currency appreciation.
Currency Appreciation - It refers to a situation when domestic currency appreciates or gains its value in relation to a foreign currency.
3.) Impact of decrease in supply of a foreign currency -
Assumption : OR : 1 US$ = 60 Rs
OR1 : 1 US$= 70 Rs
Supply curve shifts from S to S1. This causes a rise in the equilibrium exchange rate from OR to OR1. Now One US$ is available for 70 Rs instead of 60 Rs.
This is a situation of depreciation of the domestic currency.
4.) Impact of increase in supply of a foreign currency -
Supply curve shifts from S to S1. This causes a fall in the equilibrium exchange rate from OR to OR1. Now one US $ is available for 50 Rs instead of 60 Rs. It is a situation of appreciation of domestic currency.
Fixed Exchange Rate
It is that rate which is set and maintained by the government.
The govt. may set it at a level higher or lower than the equilibrium exchange rate as determined by the market forces of supply and demand.
It is of two types:-
1.) Gold standard system of exchange rate.
2.) Bretton woods system of exchange rate.
1.) Gold standard system of exchange rate - According to this system, gold was taken as the common unit of parity between currencies of different countries.
Each country was to define value of its currency in terms of gold. According value of One currency in terms of the other currency was fixed considering the gold value of each currency.
This system of exchange was also known as Mint Parity of exchange or Mint Parity .
2.) Bretton Woods System of Exchange - It allowed some adjustments even when it was a fixed system of exchange rate. So it was also called Adjustable Peg System of Exchange rate . According to this system :
1.) Different currencies were pegged or related by one currency, that is US dollar.
2.) US dollar was assigned gold value at a fixed price.
3.) Value of One currency in terms of US dollar ultimately implied value of that currency in terms of Gold.
4.) Gold continued to be the ultimate unit of parity between any two currencies.
5.) Adjustment in the parity value of a currency was possible but only if allowed by IMF(International Monetary Fund).
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