CH-11 Foreign Exchange Rate

Ques-1 Define foreign exchange, foreign exchange sate and foreign exchange market?

Ans- 1 Foreign exchange refers to foreign currency that is all the currencies used in in the world other than domes c
currency.

2 Foreign exchange rate - It is the rate at which currency of one na on is exchanged by the currency of other na on.
In other words it is the value of one currency in terms of another currency.

3. Foreign exchange Market - It is the Market Where currency of Various na ons are converted, traded or
exchanged.

Ques-2 What do you mean by fixed and flexible exchange rate system?

Ans- Fixed Exchange rate system-It refers to that system of foreign exchange in which rate of foreign exchange is
officially fixed by the government and not by Market forces. Foreign Banks buy and sell their currencies at a fixed
rate. The basic purpose of adop ng this system is to assure stability in foreign trade and Capital Movement. This
system was used under gold standard system when value of currency was determined in terms of goal and was
known as parity value of currency.

Flexible Exchange rate system

It refers to that system of foreign exchange in which rate of foreign exchange is determined by market forces of
Demand and supply of foreign exchange. There is no official interven on by government or monetary authority
rather Foreign exchange rate is allow to adjust freely according to change in demand and supply of foreign exchange.
It is also called Floa ng Exchange Rate system.

Ques-3 What do you mean by deprecia on of currency. Explain its impacts on exports and imports. How is it
different from devalua on of currency?

Ans- Deprecia on of currency - It refers to fall in the value of domes c currency in terms of foreign currency for ex lf
price of 1 US $ increased from Rs 50 to Rs 60 then it is the deprecia on of Indian currency because more Indian
rupee is now required to buy one US $.

Exports and Imports

 With deprecia on of currency, domes c product become cheaper for the foreigners. Then it will increase
Demand of domes c product by the foreigners and thereby increases exports of na on.
 With deprecia on of currency, foreign product become expensive for the people of domes c country and it
decreases the demand of foreign goods and thereby reduces the imports of country.

Ques-4 Difference between Deprecia on & Devalua on.

Ans-

Deprecia on Devalua on
1. It refers to fall in the value of domes c currency 1. It refers to fall in the value of domes c currency
in terms of foreign currency by the market in terms of foreign currency by the government.
forces of demand and supply.

2. It is done under flexible exchange rate. 2. It is done under fixed exchange rate.

Ques -5 what do you mean by apprecia on of currency. Explain its impact on exports and Imports. How it is
different from Revalua on of currency.
Ans- Apprecia on of currency - It refers to increase in the value of domes c currency in terms of foreign currency.
for ex- If price of 1 US dollar decreases from ₹ 60 to ₹ 30 then it is the apprecia on of Indian currency because Less
Indian rupee is now required to buy one US dollar.

Exports and Imports

 With apprecia on of currency, domes c product become expensive for the foreigners then it will decrease
demand of domes c product by the foreigners and thereby decreases exports of na on.
 With apprecia on of currency, foreign product become cheaper for the people of domes c country and it
increases the demand of foreign goods and thereby Increases the Imports of country.

Ques-6 Why does demand for foreign exchange rises as the exchange rate falls?

Ans - Demand for foreign exchange is inversely related to foreign exchange rate due to Following reasons-

1 When foreign exchange rate falls then it makes foreign product cheaper for the people of domes c country
so it increases Imports and thereby Increases the demand for foreign exchange.

2) when price of foreign currency in terms of domes c currency falls then it promotes foreign tourism as it
also becomes cheaper thus demand for foreign exchange rises.

3) When the rate of foreign exchange falls, Its demand rises because more people wants to make gain from
specula ve ac vi es in abroad.

Ques-7 Why does supply of foreign exchange rises as foreign exchange rate rises?

Ans- Supply of foreign exchange is directly related to rate of foreign exchange due to following reasons:

1) When rate of foreign exchange rises that makes domes c product cheaper for the foreigners so it increases
exports of country and thereby increases the supply of foreign exchange.

2) When the price of foreign currency increases in terms of domes c currency then it promotes tourism of
domes c country. Its tour of domes c currency become cheaper for the foreigners and thereby Increases the
supply for foreign exchange.

3) When the rate of foreign exchange rises, Its supply also rises as more foreign people wants to make gain from
specula ve ac vi es in the domes c country.

Ques-8 How does equilibrium foreign exchange rate determine in the foreign exchange Market ?

Ans- In a free market, foreign exchange rate is determined by market forces of demand and supply of foreign
exchange.

Demand for foreign exchange is inversely related to rate of foreign exchange therefore demand curve for foreign
exchange is downward Shaping from le to right.

Supply of foreign exchange is directly related to rate of foreign exchange therefore supply curve for foreign
exchange is upward sloping from le to right

The equilibrium rate of foreign exchange is a ained where demand and supply of foreign exchange are equal. It
is shown by the following diagram.
In the above diagram, at the exchange rate R2, there is excess supply, leads to compe on among sellers and
exchange rate tends to fall.

All the exchange rate R1, there is excess demand, leads to compe on among the buyers and rate tends to rise.

The equilibrium foreign exchange rate is a ained where demand and supply are equal i.e. R in the diagram.

Ques-9 Impact of following on the foreign exchange rate

(a) Government doubles import duty on gold

Increased Import duty on gold will make imports of gold costly. It will reduce demand for import of gold and
consequently of foreign exchange.
Hence demand curve will shi le ward. Supply of foreign exchange remaining unchanged price of foreign
exchange (FER) is likely to fall (In diagram from OR to OR1) and quan ty will fall as well (In diagram from OQ
to OQ1)
(b) Government provides exports incen ves to producers
 Increased exports incen ve on producers will encourage and increase exports of na on. It will increase
supply of foreign exchange and supply curve will shi rightward.

Hence demand of foreign exchange remaining unchanged, price of foreign exchange will decrease (In diagram
from OP1 to OP2) and quan ty will increase (In diagram from OQ1 to OQ2)

(c) Indian Investors lends to abroad

If Indian investors will lend to abroad, then demand for foreign exchange will rise and demand curve will shi
rightward.
Hence supply of foreign exchange remaining unchanged, price of foreign exchange (FER) will increase (In
diagram from OE to OE1) and quan ty will increase as well (In diagram from OQ to OQ1)

(d) Increase in foreign Investment

Increase in foreign investment will increase supply of foreign exchange which will shi supply curve
rightward.
Hence demand of foreign exchange remaining unchanged, price of foreign exchange (FER) will decrease (In
diagram from OP1 to OP2) and quan ty will increase (In diagram from OQ1 to OQ2).

Ques- What do you mean by managed floa ng system ?

Ans It refers to that system in which foreign exchange rate is determined by market forces and central bank
influences the exchange rate through interven on in the foreign exchange market.
It is the hybrid of flexible and fixed exchange rate system. In this system Central Bank Intervene in the foreign
exchange market to restrict the fluctua ons in the exchange rate within certain limits. For this central Bank maintain
the reserve of foreign exchange to ensure that foreign exchange rate stay within certain limits. It is also known as
Dirty floa ng systems.

FOREIGN EXCHANGE RATE - HOTS HIGHER ORDER THINKING SKILLS QUESTIONS

Q1. Suppose the present foreign exchange rate is 1 $ = Rs. 80. It rises to 1 $ = Rs 85 leading to rise in prices of
imports of essen al goods. How can Reserve Bank of India help in bringing down the foreign exchange rate which
is very high?

Ans. Rise in exchange rate from 1 $ = Rs.80 to 1$ = Rs.85 means deprecia on of Indian currency. Foreign goods
become costlier. Prices of imports of essen al goods rise. So, imports decrease. The Reserve bank of India should sell
US Dollars from its foreign exchange reserves. As a result, supply of foreign exchange (dollars) in the foreign exchange
market increases. It will lead to fall in the foreign exchange rate.

Q2. What is the role of a Central Bank in the following exchange rate?

(a) Fixed exchange (b) Floa ng exchange (c) Managed floa ng

Ans. The role of the Central Bank in maintaining foreign exchange rates under different regimes is :

(a) Fixed exchange rate system: A Central Bank ac vely uses its foreign currency reserves to maintain the officially
determined exchange rate.

(b) Floa ng exchange rate system: A Central Bank docs not maintain any reserves of foreign currency as the market
automa cally adjusts to determine the market driven exchange rate.

(c) Managed Floa ng: A Central Bank enters the foreign exchange market to buy/sell foreign currency in order to
control fluctua ons and vola lity in the market.

Q3. "Foreign Ins tu onal Investors (FIIs) remained net seller in the Indian capital markets over the last few
weeks." - The Economic Times
State and discuss the likely effects of the given statement on foreign exchange rate with reference to the Indian
Economy.

Ans. Selling of securi es by Foreign Ins tu onal Investors (FIIs) in Indian capital market will lead to fall in the supply
of foreign currency in the economy This situa on might lead to excess demand of foreign currency at the prevailing
foreign exchange rate.

As a result, a new equilibrium rate of foreign exchange will be determined which will be higher than the prevailing
foreign exchange rate, leading to deprecia on of domes c currency.

Q4. "Many large Mul na onal Corpora ons (MNCs) have recently shi ed their investments from China and have
started their produc on in India, thereby boos ng the Make in India plans of the Government." Presuming other
factors being constant, discuss the effects of the given statement on Foreign Exchange rates with reference to the
Indian Economy.

Ans. Investments by large mul na onal corpora ons (MNCs) in India will ensure greater inflow of foreign exchange,
leading to an increase in the supply of foreign currency. This situa on may result into excess supply of foreign
currency in the economy at the prevailing foreign exchange rate.
As a result, a new equilibrium rate of foreign exchange will be determined which will be lower than the prevailing
foreign exchange rate, leading to apprecia on of domes c currency.

Q5. Explain the effect of rise in income at home on foreign exchange rate.

Ans. When income of people of India increases, consumer spending increases. Spending on imported goods is also
likely to increase. When imports increase, the demand for foreign exchange rises. This situa on might lead to excess
demand of foreign currency at the prevailing foreign exchange rate. As. a result, a new equilibrium rate of foreign
exchange will be determined which will be higher than the prevailing foreign exchange rate, leading to deprecia on
of domes c currency. Thus, foreign exchange rate likely to rise.

Q6. Explain the impact of rise in exchange rate on na onal income.

Ans. A rise in exchange rate, say rupee-dollar exchange rate rises from Rs.80/$ to Rs.85/$, denotes deprecia on of
Indian Currency (rupee). Indian goods will become cheaper to foreigners because they can now buy more goods with
one unit of foreign currency (dollars). Exports become cheaper. So, exports will increase.

On the contrary, our imports become costlier because importers have to pay more rupees to buy one unit of foreign
currency worth goods. So, imports will decrease. As a result, net exports (i.e., exports - imports) will increase. Since
net exports is a component of aggregate demand, therefore, aggregate demand will increase [AD = C + I + G + (X-M)].
Increase in aggregate demand will increase the na onal income.

Q7. "Indian rupee (Rs.) plunged to all me low of Rs. 80 against the US Dollar ($)". -The Economic Times

In the light of the above report, discuss the impact of the situa on on Indian Imports, Exports and BoP posi on of
India.

Ans. Indian rupee plunged to all me low of Rs.80 against US dollar. It is called deprecia on in the value of Indian
Rupees. It may lead to fall in imports as foreign goods will become costlier for the domes c consumers. Fall in
imports less ou low of foreign exchange from the country.

Also, deprecia on of rupee causes increase in exports of India since interna onal compe veness of Indian good:
gets be er. So, there will be more inflow of foreign exchange into the country. Thus, net inflow of foreign exchange
increases which has favourable effect on the Balance of Payments posi on.

Q8. According to recent media reports: 'USA has accused China of currency devalua on to promote its exports'. In
the light of the given media report comment, how exports can be promoted through the Currency devalua on?

Ans. USA has a valid point of argument as devalua on of a currency encourages exports of a country. As exported
goods become cheaper in the interna onal market giving a compe ve edge for the goods of domes c country
(China).

Devalua on of the value of domes c currency promotes the exports of the country and may adversely impact the
produc on and sale of impor ng country (USA).

Q9. How does foreign exchange specula on affect the exchange rate? Explain with an example.

Ans. Foreign exchange rate is affected by foreign exchange specula on where foreign exchange is demanded for the
possible gains from apprecia on of foreign currency. Suppose the investors believe that the Rupee-Dollar exchange
rate is going to rise from Rs. 70/$ to Rs. 75/$ by the end of the month. They think if they took Rs.70,000 and bought
1000 dollars, at the end of the month they would be able to exchange the dollars for Rs.75000, thus making a profit
of Rs. 5000. This expecta on would increase the demand for dollars. Supply of foreign exchange remaining
unchanged, increase in demand will cause the exchange rate to rise in the present.
Q10. What is the effect of rise in interest rates at home on the foreign exchange rate? Explain.

Ans. A rise in interest rates at home will a ract foreign investors to invest in the home country. This will lead to
inflow of more foreign currency (ie. increase in supply of foreign exchange).

Demand of the foreign exchange remaining unchanged, the exchange rate is likely to fall causing apprecia on of the
domes c currency and deprecia on of the foreign currency.

Q11. Suppose a shirt costs $10 in the US and Rs. 600 in India, what will be the effect on exports of India if the
rupee-dollar exchange rate is Rs. 80/$?

Ans. At the exchange rate Rs. 80/$, it costs Rs. 800 per shirt in the US but only Rs. 600 in India. That is, interna onal
compe veness of shirts reduced in India gets be er. In that case, all foreign customers would buy shirts from India.
Thus, exports of shirts from India will increase.