Foreign Exchange Rate: Meaning and

Exchange Rate Determination

1. Meaning:
If a Kashmiri shawlmaker sells his goods to a buyer in
Kanyakumari, he will receive in terms of Indian rupee.
This suggests that domestic trade is conducted in terms of
domestic currency. But if the Indian shawl- maker decides to
go abroad, he must exchange Indian rupee into franc or dollar
or pound or euro.
To facilitate this exchange form, banking institutions appear.
Indian shawlmaker will then go to a bank for foreign
currencies. The bank will then quote the day’s exchange rate—
the rate at which Indian rupee will be exchanged for foreign
currencies. Thus, foreign currencies are required in the
conduct of international trade.
In a foreign exchange market comprising commercial banks,
foreign exchange brokers and authorised dealers and the
monetary authority (i.e., the RBI), one currency is converted
into another currency.
A (foreign) exchange rate is the rate at which one currency is
exchanged for another. Thus, an exchange rate can be
regarded as the price of one currency in terms of another. An
exchange rate is a ratio between two monies. If 5 UK pounds
or 5 US dollars buy Indian goods worth Rs. 400 and Rs. 250
then pound- rupee or dollar-rupee exchange rate becomes Rs.
80 = £1 or Rs. 50 = $1, respectively. Exchange rate is usually
quoted in terms of rupees per unit of foreign currencies. Thus,
an exchange rate indicates external purchasing power of
money.
A fall in the external purchasing power or external value of
rupee (i.e., a fall in exchange rate, say from Rs. 80 = £1 to Rs.
90 = £1) amounts to depreciation of the Indian rupee.
Consequently, an appreciation of the Indian rupee occurs
when there occurs an increase in the exchange rate from the
existing level to Rs. 78 = £1.
In other words, external value of the rupee rises. This
indicates strengthening of the Indian rupee. Conversely, the
weakening of the Indian rupee occurs if external value of
rupee in terms of pound falls. Remember that each currency
has a rate of exchange with every other currency.
Not all exchange rates but about 150 currencies are quoted,
since no significant foreign exchange market exists for all
currencies. That is why exchange rate of these national
currencies are quoted usually in terms of US dollars and
euros.
2. Exchange Rate Determination:
Now two pertinent questions that usually arise in the foreign
exchange market are to be answered now. Firstly, how is
equilibrium exchange rate determined and, secondly, why
exchange rate moves up and down?
There are two methods of foreign exchange rate
determination. One method falls under the classical gold
standard mechanism and another method falls under the
classical paper currency system. Today, gold standard
mechanism does not operate since no standard monetary unit
is now exchanged for gold.
All countries now have paper currencies not convertible to
gold. Under inconvertible paper currency system, there are
two methods of exchange rate determination. The first is
known as the purchasing power parity theory and the second
is known as the demand-supply theory or balance of payments
theory. Since today there is no believer of purchasing power
parity theory, we consider only demand-supply approach to
foreign exchange rate determination.
1. Demand-Supply Approach of Foreign Exchange, Or
BOP Theory of Foreign Exchange:
Since the foreign exchange rate is a price, economists apply
supply-demand conditions of price theory in the foreign
exchange market. A simple explanation is that the rate of
foreign exchange equals its supply. For simplicity, we assume
that there are two countries: India and the USA. Let the
domestic currency be rupee. US dollar stands for foreign
exchange and the value of rupee in terms of dollar (or
conversely value of dollar in terms of rupee) stands for foreign
exchange rate. Now the value of one currency in terms of
another currency depends upon demand for and supply of
foreign exchange.
(i) Demand for foreign exchange:
When Indian people and business firms want to make
payments to the US nationals for buying US goods and
services or to make gifts to the US citizens or to buy assets
there, the demand for foreign exchange (here dollar) is gen-
erated. In other words, Indians demand or buy dollars by
paying rupee in the foreign exchange market.
A country releases its foreign currency for buying imports.
Thus, what appears in the debit side of the BOP account is the
sources of demand for foreign exchange. The larger the
volume of imports the greater is the demand for foreign
exchange.
The demand curve for foreign exchange is negative sloping. A
fall in the price of foreign exchange or a fall in the price of
dollar in terms of rupee (i.e., dollar depreciates) means that
foreign goods are now more cheaper.
Thus, an Indian could buy more American goods at a low
price. Consequently, imports from the USA would increase
resulting in an increase in the demand for foreign exchange,
i.e., dollar. Conversely, if the price of foreign exchange or price
of dollar rises (i.e., dollar appreciates) then foreign goods will
be expensive leading to a fall in import demand and, hence,
fall in the demand for foreign exchange.
Since price of foreign exchange and demand for foreign
exchange move in opposite direction, the importing country’s
demand curve for foreign exchange is downward sloping from
left to right.
In Fig. 5.4, DD1 is the demand curve for foreign exchange. In
this figure, we measure exchange rate expressed in terms of
domestic currency that costs 1 unit of foreign currency (i.e.,
dollar per rupee) on the vertical axis. This makes demand
curve for foreign exchange negative sloping.

If exchange rate is expressed in terms of foreign currency that

could be purchased with 1 unit of domestic currency (i.e.,
dollar per rupee), the demand curve would then exhibit
positive slope. Here we have chosen the former one.
(b) Supply of foreign exchange:
In a similar fashion, we can determine supply of foreign
exchange. Supply of foreign currency comes from its receipts
for its exports. If the foreign nationals and firms intend to
purchase Indian goods or buy Indian assets or give grants to
the Government of India, the supply of foreign exchange is
generated.
In other words, what the Indian exports (both goods and
invisibles) to the rest of the world is the source of foreign
exchange. To be more specific, all the transactions that appear
on the credit side of the BOP account are the sources of supply
of foreign exchange.
A rise in the rupee-per-dollar exchange rate means that
Indian goods are cheaper to foreigners in terms of dollars.
This will induce India to export more. Foreigners will also find
that investment is now more profitable. Thus, a high price or
exchange rate ensures larger supply of foreign exchange.
Conversely, a low exchange rate causes exchange rate to fall.
Thus, the supply curve of foreign exchange, SS1, is positive
sloping.
Now we can bring both demand and supply curves together to
determine foreign exchange rate. The equilibrium exchange
rate is determined at that point where demand for foreign
exchange equals supply of foreign exchange. In Fig. 5.4,
DD1 and SS1 curves intersect at point E. The foreign exchange
rate thus determined is OP. At this rate, quantities of foreign
exchange demanded (OM) equals quantity supplied (OM).
The market is cleared and there is no incentive on the part of
the players to change the rate determined.
Suppose that at the rate OP, Rs. 50 = $1, demand for foreign
exchange is matched by the supply of foreign exchange. If the
current exchange rate OP1 exceeds the equilibrium rate of
exchange (OP) there occurs an excess supply of dollar by the
amount ‘ab’. Now the bank and other institutions dealing with
foreign exchange—wishing to make money by exchanging
currency—would lower the exchange rate to reduce excess
supply.
ADVERTISEMENTS:

Thus, exchange rate will tend to fall until OP is reached.

Similarly, an excess demand for foreign exchange by the
amount ‘cd’ arises if the exchange rate falls below OP, i.e.,
OP2. Thus, banks would experience a shortage of dollars to
meet the demand. Rate of foreign exchange will rise till
demand equals supply.
The exchange rate that we have determined is called a floating
or flexible exchange rate. (Under this exchange rate system,
the government does not intervene in the foreign exchange
market.) A floating exchange rate, by definition, results in an
equilibrium rate of exchange that will move up and down
according to a change in demand and supply forces. The
process by which currencies float up and down following a
change in demand or change in supply forces is, thus,
illustrated in Fig. 5.5.

Let us assume that national income rises. This results in an

increase in the demand for imports of goods and services and,
hence, demand for dollar rises. This results in a shift in the
demand curve from DD1 to DD2. Consequently, exchange rate
rises as from OP1 to OP2 determined by the intersection of new
demand curve and supply curve. Note that dollar appreciates
from Rs. 50 = $1 to Rs. 53 = $1, while rupee depreciates from
$1 = Rs. 50 to $1 = Rs. 53.
ADVERTISEMENTS:

Similarly, if supply curve shifts from SS1 to SS2, as shown in

Fig. 5.6, new exchange rate thus determined would be OP2. If
Indian goods are exported more, following an increase in
national income of the USA, the supply curve would then shift
rightward. Consequently, dollar depreciates and rupee appre-
ciates. New exchange rate is settled at that point where the
new supply curve (SS2) intersects the demand curve at E2.
This is the balance of payments theory of exchange rate
determination. Wherever government does not intervene in
the market, a floating or a flexible exchange rate prevails.
Such system may not necessarily be ideal since frequent
changes in demand and supply forces cause frequent as well
as violent changes in exchange rate. Consequently, an air of
uncertainty in trade and business would prevail.
Such uncertainty may be damaging for the smooth flow of
trade. To prevent this situation, government intervenes in the
foreign exchange rate. It may keep the exchange rate fixed.
This exchange rate is called a fixed exchange rate system
where both demand and supply forces are manipulated or
calibrated by the central bank in such a way that the exchange
rate is kept pegged at the old level.
Often managed exchange rate is suggested. Under this system,
exchange rate, as usual, is determined by demand for and
supply of foreign exchange. But the central bank intervenes in
the foreign exchange market when the situation demands to
stabilise or influence the rate of foreign exchange. If rupee
depreciates in terms of dollar, the RBI would then sell dollars
and buy rupee in order to reduce the downward pressure in
the exchange rate.