Economy Simplified: The Foreign Exchange Market explained.

1. The market in which national currencies are traded for one another is known as the foreign exchange market.
2. The major participants in the foreign exchange market are commercial banks, foreign exchange brokers and other authorised dealers and monetary authorities.

Foreign Exchange Rate

1. Foreign Exchange Rate (also called Forex Rate) is the price of one currency in terms of another. 
2.It links the currencies of different countries and enables comparison of international costs and prices. For example, if we have to pay Rs 50 for $1 then the exchange rate is Rs 50 per dollar.

Demand and supply dynamics in Foreign Exchange market

To make it simple, let us consider that India and the USA are the only countries in the world and so there is only one exchange rate that needs to be determined.
  • Demand for Foreign Exchange
    • People demand foreign exchange because: they want to purchase goods and services from other countries; they want to send gifts abroad; and they want to purchase financial assets of a certain country.
    • A rise in the price of foreign exchange will increase the cost (in terms of rupees) of purchasing a foreign good. This reduces demand for imports and hence demand for foreign exchange also decreases, other things remaining constant. 
    • Supply of Foreign Exchange
      • Foreign currency flows into the home country due to the following reasons: exports by a country lead to the purchase of its domestic goods and services by the foreigners; foreigners send gifts or make transfers; and, the assets of a home country are bought by the foreigners.
      • A rise in the price of foreign exchange will reduce the foreigner’s cost (in terms of USD) while purchasing products from India, other things remaining constant. This increases India’s exports and hence supply for foreign exchange may increase (whether it actually increases depends on a number of factors, particularly elasticity of demand for exports and imports.

    Determination of the Exchange Rate

    Different countries have different methods of determining their currency’s exchange rate.
    It can be determined through Flexible Exchange Rate, Fixed Exchange Rate or Managed Floating Exchange Rate.
    Flexible Exchange RateThis exchange rate is determined by the market forces of demand and supply. It is also known as Floating Exchange Rate. 
    Fixed Exchange RatesIn this exchange rate system, the Government fixes the exchange rate at a particular level.  In a fixed exchange rate system, when some government action increases the exchange rate (thereby, making domestic currency cheaper) is called DEVALUATION. On the other hand, a REVALUATION is said to occur, when the Government decreases the exchange rate (thereby, making domestic currency costlier) in a fixed exchange rate system.
    Managed FloatingWithout any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system. It is a MIXTURE of a flexible exchange rate system (the float part) and a fixed rate system (the managed part). Under this system, also called DIRTY FLOATING, central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriateOfficial reserve transactions are, therefore, not equal to zero.

    Foreign Exchange Market and its influence on Appreciation and Depreciation of domestic Currency 

    • Let us assume that the exchange rate is a flexible exchange rate i.e.  the exchange rate is determined by the market forces of demand and supply.
    • As depicted in Fig. 6.1, the exchange rate is determined where the demand curve intersects with the supply curve, i.e., at point e on the Y – axis. Point q on the x – axis determines the quantity of US Dollars that have been demanded and supplied on e exchange rate. 
    • Suppose the demand for foreign goods and services increases (for example, due to increased international travelling by Indians), then as depicted in Fig. 6.2, the demand curve shifts upward and right to the original demand curve. The increase in demand for foreign goods and services result in a change in the exchange rate. The initial exchange rate e0 = 50 which means that we need to exchange Rs 50 for one dollar.
    • At the new equilibrium, the exchange rate becomes e1 = 70, which means that we need to pay more rupees for a dollar now (i.e., Rs 70). It indicates that the value of rupees in terms of dollars has fallen and value of dollars in terms of rupees has risen.
      Increase in exchange rate implies that the price of foreign currency (dollar) in terms of domestic currency (rupees) has increased.
      This is called DEPRECIATION of domestic currency (rupees) in terms of foreign currency (dollars).
      Similarly, in a flexible exchange rate regime, when the price of domestic currency (rupees) in terms of foreign currency (dollars) increases, it is called APPRECIATION of the domestic currency (rupees) in terms of foreign currency (dollars).
      This means that the value of rupees relative to the dollar has risen and we need to pay fewer rupees in exchange for one dollar.

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