Economics Ch - 11 Class 12th (Foreign Exchange Rate) Part - 2

 Ch - 11 (Foreign Exchange Rate) Part - 2

⇒When Exchange Rate is set higher than the equilibrium exchange rate - 

S shows the supply of US $ and D shows the demand of US $.

 OR is the equilibrium exchange rate : 1 US $ is exchanged for 50 Rs.

 OR1 is the exchange rate set by the govt. Here, 1 US $ is exchanged for 60 Rs. Thus the value of domestic currency has been deliberately lowered by the government. This is called Devaluation.

Implications of Devaluation :- 

Devaluation leads to Excess Supply of Foreign currency in the International money market. This would lead to a fall in the exchange rate.

In this situation the purpose of the devaluation would be lost. therefore, becomes essential for the government to absorb the excess supply by way of its own purchase of foreign currency in international money market. Accordingly, the government reserves of foreign exchange must rise.

Devaluation ⇾ Excess money supply in market ⇾ Fall in exchange rate ⇾ Government purchase the foreign currency in international money market ⇾ Government reserves of foreign exchange must rise.

⇒When Exchange Rate is set lower than the equilibrium exchange rate - 

                                                              

OR is the equilibrium exchange rate : 1 US $ is exchanged for 50 Rs.

OR1 is the exchange rate as fixed by the government. Here 1 US $ is exchanged for 40 Rs.

   Thus, the value of domestic currency has been deliberately raised by the government. This is called revaluation.

Implications of Revaluation :- 

Revaluation leads to excess demand for foreign currency in the international money market.

 The RBI must fulfill this excess demand by releasing supplies from its reserves of foreign exchange.

In case of supplies are not released from the reserves of foreign exchange these may emerge a black market for the sale and purchase of dollars.

                                  Managed Floating

Managed floating is a system of floating exchange rate in which there is occasional intervention by the Central Bank to influence the float or manage the float. It is also called Dirty Floating.

It is done by central bank through the sale and purchase of foreign currency. When the exchange rate needs to be reduced, the central bank releases the supply of US $ in foreign exchange market. Other things remaining constant,higher supply US $ would lower the price of US $ as desired. This lead to Appreciation of domestic currency.

On the other hand, when the exchange rate needs to be raised, the central bank increases its demand for US $ in the foreign exchange market.  Other things remaining constant, higher demand for US $ would raise the the price of US $ as desired. This would lead to Depreciation of domestic currency.

Why is Foreign Exchange Demanded :-

1. Repayment of International Loan :- International loans are raised in terms of foreign currency.Accordingly foreign currency is required for the repayment of these loans.

2. Investment in the rest of the world :- It is an important business activity,we need currency of the country in which investment is to be made.

3. Imports :- We import goods and services from the rest of the world. It requires foreign exchange because payments for imports are made in foreign exchange only.

4. Direct purchasing from abroad :- Foreign exchange is needed to make direct purchase of goods and services from abroad.

5. Grants and Donation :- Grants and Donation to the rest of the world also contribute to the demand for foreign exchange. It is to be made in terms of the currency of that country.

6. Speculation Trading :- Foreign exchange is demanded by the people for purpose of speculative trading.

    Why is Foreign Exchange Supplies :-

1. Exports :- Exports of goods and services is an important source of foreign exchange in rest of the world.

2. Investment from rest of the world :- It is another important source of supply of foreign exchange. Lots of foreign exchange flows from developed countries to underdeveloped countries through this channel of economic activity.

3. Direct purchases by rest of the world :- It also contribute to the flow of foreign exchange rate of the world to the domestic economy.

4. Loans from rest of the world :- It refers to the borrowing from rest of the world. It contributes to the supply of foreign exchange to India.

5. Grants and donation from rest of the world :- A significant amount of foreign exchange flows from rich to the poor countries of the world by way of grants and donation.

6. Income receipts :- Foreign exchange also flows from rest of the world to the domestic economy by way of income receipts. The receipts refers to factor income from rest of the world.

                  Foreign Exchange Market :-

It refers to the market of national currencies of different countries in the world.

Functions  -

1.) Transfer Function  - It implies transfer of purchasing power in terms of foreign exchange across different countries of the world.

2.) Credit Function  - It implies provision of credit in terms of foreign exchange for the export and import of goods and services across different countries of the world.

3.) Hedging Function  - It implies protection against risk related to variations in foreign exchange rate. Exchange rate is locked for future supplies of foreign exchange.

Operations of Foreign Exchange Method - 

1.) Spot Market ( Current Market )  - It is that market which handles only spot transactions or current transaction.

    Characteristics  -

a) It is of daily nature. It does not make a trade of Future deliveries.

b) The rate of exchange which is determined in the spot market is known as spot rate of exchange.

2.) Forward Market  - It is that market which handles such transactions of foreign exchange that are meant for future delivery.

     Characteristics  -

a) It only caters to forward transactions.

b) It defines forward exchange rate - the rate at which forward transactions are to be made.