Foreign Exchange Rate Class 12 Notes – CBSE Economics Chapter

Introduction of CBSE Exchange Rate Class 12

In foreign exchange rate class 12, we will study about the foreign exchange
rates, depreciation and appreciation of currencies, determination of foreign
exchange rate and foreign exchange markets.

Every country has their own currency to exchange goods and services. But
the currency of one country is not acceptable in the other country. For this
purpose, we need foreign exchange rate to convert the domestic
currency into foreign currency.
FOREIGN EXCHANGE RATE
It is the exchange rate at which one currency is exchanged for other currency
in the exchange rate market. It represents the price of one currency in terms
of other currency.

This exchange rate depends upon the demand and supply of foreign
exchange with other countries indulged in exchanging. For example, the value
of $1 is equals to Rs. 76.

DEPRECIATION V/S APPRECIATION

Currency Depreciation
• It refers to decrease in the value of domestic currency in relation to the
foreign currency.
• It means the value of domestic currency is less than the value of foreign
currency and domestic currency is required in more number to buy the
foreign currency.
• It is caused because of (1) increase in demand, or (2) decrease in
supply.
• Due to depreciation of domestic currency, the exports will rise because
the domestic currency becomes relatively cheaper and the foreign
country will purchase more from the domestic country.
• The imports will fall because the domestic country need to pay more
currency to buy same amount of goods and services.

Currency Appreciation
 • It refers to increase in the value of domestic currency in relation to the
foreign currency.
• It means the value of domestic currency is more than the value of
foreign currency and domestic currency is required in less number to
buy foreign currency.
• It is caused because of (1) decrease in demand, or (2) increase in
supply.
• Due to appreciation of domestic currency, the exports will fall because
domestic currency becomes relatively expensive and foreign country will
purchase less from domestic country.
• The imports will rise because the domestic country will be able to buy
more with the same amount of currency.

TYPES OF EXCHANGE RATE SYSTEMS

There are 3 types of Foreign Exchange Rate Systems:

1. Fixed exchange rate system

2. Flexible exchange rate system
3. Manages floating exchange rate system
FIXED EXCHANGE RATE SYSYTEM
• It refers to the system in which exchange rate for the currency is fixed
by the government. The main aim of this system is to fix the exchange
rate and ensure stability in foreign exchange.
 • In this system, each country keeps something as a common unit, such
as gold or any other precious metal, as some external standard. With
the help of this, the exchange rate with the other country is determined
by the value of difference between the external unit kept by both the
countries.
• When the value of currency is fixed in terms of other currency, it is
known as parity value.
• Fixed exchange rate is of two types:
1.
1. Gold Standard System: In this system, the value of all the
currencies is measured by keeping something as a common unit. In
this system, the common unit is taken as gold. Each country keeps
the amount of gold they have and the excess and deficit of gold
between the countries decides the foreign exchange rate.
2. Adjustable Peg System: In this system, the value of currencies is
pegged or fixed to a major currency. Under this system ,all the
currencies were pegged to US dollars at a fixed exchange rate.
3.
• This gives rise to the devaluation and revaluation of domestic
currency. Devaluation refers to the decrease in the value of domestic
currency intentionally done by the government. Revaluation refers to
increase in the value of domestic currency intentionally done by the
government.
FLEXIBLE EXCHANGE RATE SYSTEM
• It refers to a system in which exchange rate is determined by the forces
of demand and supply of the foreign currencies in the foreign exchange
market.
• This system of exchange is also called ‘Floating Exchange Rate’.
• There is no intervention of the government in fixing the exchange rate.
• This gives rise to the depreciation and appreciation of domestic
currency in the foreign exchange market.
• In this system of exchange, the foreign exchange rate keeps on
changing continuously.
FIXED EXCHNAGE RATE SYSTEM V/S FLEXIBLE EXCHNAGE
RATE SYSTEM
Manages floating exchange rate system

• It refers to a system in which exchange rate is determined by the market

forces of demand and supply but there is some interference of the
Central banking fixing the foreign exchange rate in the foreign exchange
market.
• It a hybrid of fixed exchange rate and flexible exchange rate system.
• It is also known as ‘Dirty Floating’ as it is done by the RBI to maintain
the forex rate within the desired target value.
• The rate is freely determined by the market forces but the RBI
intervenes in between to restrict the fluctuations in the exchange rate
when it exceeds the limit.
DEMAND AND SUPPLY OF FOREIGN EXCHANGE
Demand and supply of foreign exchange happens when the countries want to
trade their goods and services internationally. This causes deprecation or
appreciation of currencies as well.

DEMAND FOR FOREIGN EXCHANGE

The demand of foreign exchange arises when the people need foreign
exchange to purchase goods or services from other countries. The demand
for foreign exchange arises because of the following reasons:

• Imports of goods and services: Foreign exchange is required to make

payment for the goods or services purchased from other country.
• Unilateral transfers to rest of the world: Foreign exchange is required
to send gifts or money to the person living abroad.
• Tourism: Foreign exchange is required to meet the expenses made
during the foreign tours.
• Speculations: Foreign exchange is required when people want to gain
money from the speculative activities or currency appreciation.
• Purchase of Assets in foreign country: Foreign exchange is required
to make payments for the purchase of land, building, shares,
debentures, bonds, etc…. in foreign countries.
• Imports of goods and services: Foreign exchange is required to make
payment for the goods or services purchased from other country.
• Unilateral transfers to rest of the world: Foreign exchange is required
to send gifts or money to the person living abroad.
• Tourism: Foreign exchange is required to meet the expenses made
during the foreign tours.
• Speculations: Foreign exchange is required when people want to gain
money from the speculative activities or currency appreciation.
• Purchase of Assets in foreign country: Foreign exchange is required
to make payments for the purchase of land, building, shares,
debentures, bonds, etc…. in foreign countries.
There exists a negative relation between foreign exchange rate and demand
for foreign exchange. The Demand curve of the foreign exchange is
‘DOWNWARD SLOPING’ because of inverse relation between demand of
foreign exchange and foreign exchange rate. When the foreign exchange rate
decreases, people demand more of foreign exchange. When the foreign
exchange rate rises, its demand decreases.

•
SUPPLY OF FOREIGN EXCHANGE
The supply of foreign exchange arises when people demand for the foreign
exchange to purchase goods or services form their country. The supply for
foreign exchange arises because of the following reasons:

• Export of goods and services: Foreign exchange is earned when

goods or services are purchased form the domestic country.
• Foreign investment: When the foreign country makes investment in
domestic country, the foreign exchange comes to the domestic country.
• Speculations: Supply of foreign exchange comes when the foreign
countries speculate on the value of foreign currency.
• Unilateral transfers from abroad: Supply of foreign exchange
increases when the foreign country gives remittance to domestic
country in form of gifts or transfers.
There exists a positive relationship between foreign exchange rate and supply
of foreign exchange. When the foreign exchange rate decreases, its supply
also falls. When foreign exchange rate rises, its supply also increases.
DETERMINATION OF FOREIGN EXCHNAGE RATE
• Foreign exchange rate is determined by the flexible exchange rate
system. In this, the forces of demand and supply meet together to
determine the foreign exchange rate.
• The point of equilibrium where demand curve of foreign exchange
meets supply curve of foreign exchange is the point of foreign exchange
rate.
• If the exchange rate rises, the demand for forex falls and the supply for
forex rises. In this case, there will be excess supply. This situation
pushes the exchange rate downwards and foreign exchange rate falls.
• If exchange rate falls, the demand for forex rises and supply for forex
falls. This will lead to excess demand. This situation pushes the
exchange rate upwards and foreign exchange rate rises.
CHANGES IN EXCHANGE RATE
The equilibrium exchange rate is changed due to changes in the demand and
supply of foreign exchange rate.

CHANGE IN DEMAND
Change in demand may be because of either ‘increase in demand’ or
‘decrease in demand’.

1. Increase in supply: Due to increase in supply, the supply curve will

shift leftwards. As a result of this, the exchange rate will fall. Due to the
fall in exchange rate, the domestic currency will be appreciated.
2. Decrease in supply: Due to decrease in supply, the supply curve will
shift rightwards. As a result of this, the exchange rate will rise. Due to
the increase in exchange rate, the domestic currency will be
depreciated.
Change in Supply Curve of Foreign Exchange
Change in supply may be because of either ‘increase in supply’ or ‘decrease
in supply’.

1. Increase in supply: Due to increase in supply, the supply curve will

shift to leftwards. As a result of this, the exchange rate will fall. Due to
the fall in exchange rate, the domestic currency will be appreciated.
2. Decrease in supply: Due to decrease in supply, the supply curve will
shift to rightwards. As a result of this, the exchange rate will rise. Due to
the increase in exchange rate, the domestic currency will be
depreciated.
FOREIGN EXCHNAGE MARKET
Foreign exchange market is the market where the foreign currencies are
bought and sold. The foreign exchange market is not a place but a system
where the exchange rate is determined and foreign currencies are exchanged.

The buyers and sellers of foreign currency includes individual, firms,

commercial banks, central bank and foreign exchange brokers.

FUNCTIONS OF FOREIGN EXCHANGE MARKET

Foreign exchange market performs the following functions:

1. Transfer function: This function transfers the purchasing power

between the countries involving in purchasing and selling of foreign
exchange.
2. Credit function: It provides credit to the foreign countries in terms of
foreign currency for the purpose of international payments.
3. Hedging functions: This functions of foreign exchange market
provides security form the risk of fluctuation of prices in the foreign
exchange market. When seller and buyer enter into an agreement for a
future date at the current year price, it is called hedging. This is done to
avoid the losses that might be caused due to exchange rate variation.
TYPES OF FOREIGN EXCHNAGE MARKET:
Foreign exchange markets can be classified into two types: Spot and
Forward.

1. Spot market: Spot market is a market in which the exchange of

currencies is done immediately. This market is of daily nature and deals
only in on the spot transactions. The rate of exchange at which
transactions in spot market are dealt is known as spot exchange
rate or current exchange rate.
2. Forward market: Forward market refers to the market in which the
exchange of currencies is fixed for a future date at the current rate of
foreign exchange. Generally, the international transactions are fixed
upon an early date and completed on a future date. This is done to
minimize the risk of uncertainty and to make profits for speculative
purpose. The exchange rate at which the transactions in this market are
done is called forward exchange rate