Foreign Exchange Rate: Meaning and Types
What is Foreign Exchange Rate?
A medium of exchange for goods and services is called currency. In a nutshell, it is money issued by governments and accepted for payment in the country. It comes in the form of coins and paper. Every nation has a currency that is widely accepted within its boundaries. For example, the Indian rupee (₹) in India, the Pound (£) in England, and the Dollar ($) in the United States of America.
A country’s currency cannot be used in another country; for example, the Indian rupee (₹) can not be directly acceptable in the USA. In today’s world, countries have economic relations with each other. Thus there is an increase in interdependence among the countries. Therefore, in the case of international payments, it has to be first converted into the other country’s currency after this it can be used in economic transactions. If an Indian resident wants to visit the USA then he/she has to pay in Dollars ($) to stay there or if an Indian resident wants to purchase a certain thing from abroad then he/she has to pay in their respective currency to purchase that thing.
Thus for this purpose, the currency of one country is converted into the currency of another country and the rate at which one currency is exchanged for another is called the Foreign Exchange Rate or Foreign Rate of Exchange. In simple words, it is the price paid in domestic currency for buying a unit in foreign currency. For example, If 60 rupees are to be paid to get one dollar then the exchange rate in that case is:
$ 1 : ₹ 60
The exchange rate can be expressed as the ratio of exchange between the currencies of other countries. It is the price of one currency in terms of another currency. The exchange rate is also known as the External Value of Domestic Currency. It is the rate at which the imports and exports of a country are valued at a given point of time.
Foreign Exchange refers to the currencies of countries other than the domestic currency of a given country. In simple terms, it is the aggregation of the Foreign currencies held by the country’s government, and Securities and bonds issued by foreign companies and governments.
There are two ways to interpret the Foreign Exchange Rate:
- It is the number of units of domestic currency that are required to purchase a unit in the domestic currency. As discussed above, $1 = ₹60. Thus an Indian resident needs ₹60 to buy a unit of $(dollar).
- Similarly, it means the foreign currency required to buy a unit of the domestic currency. If we take the above example, then the price of a rupee is i.e., ₹1 = 0.167$. Thus a foreign resident needs 0.167$ to buy a unit of ₹ (rupee).
The foreign exchange rate can fluctuate on a year-to-year basis or even a day-to-day basis. A country has many foreign exchange rates as there are many foreign currencies. The rate at which it is exchanged; i.e., the exchange rate is determined by the forces of demand and supply.
Currency Depreciation and Currency Appreciation
It refers to the decrease in the value of the domestic currency (₹) in terms of one or more foreign currencies (like $). It makes domestic currency less valuable, and more is required to buy a unit of currency. For example, if the price of $1 rises from ₹60 to ₹64, then it can be said that there is a depreciation of the Indian currency.
The main factors contributing to currency depreciation are easy monetary policy and excessive inflation. It can also be caused by political instability. Due to uncertainty in the domestic country, investors fear investing in the domestic country. For example, Due to the war between Russia and Ukraine investors fear investing in the country because of instability in the economy. Besides, if the country imports large amounts of products, then there will be a trade imbalance, which will lead to currency depreciation.
Effects of Currency Depreciation on Exports
Currency depreciation means a fall in the price of domestic currency (₹) in comparison to foreign currencies ($). For example, earlier people can get goods worth ₹60 from a unit of the dollar, but now they can get goods worth ₹64 from 1$. It means that more goods can be purchased from India in rupees with the same amount of dollar. Thus it leads to an increase in exports from India to the USA, as exports become cheaper.
It refers to an increase in the value of a domestic currency (₹) in terms of one or more foreign currencies (like $). It makes the domestic currency more valuable, and less of it is required to buy a unit of currency. For example, if the price of $1 falls from ₹64 to ₹ 60, then it can be said that there is appreciation of Indian currency. The main factors contributing to currency appreciation are interest rates and inflation. In the case of low inflation, there is an increase in interest rates, and higher rates attract more investors in the overseas market, which will ultimately increase the value of the domestic currency. Another main reason is investor sentiment. If an investor feels that his/her money is safe in the economy; i.e., there is political stability in the country, then it will attract capital flows from overseas leading to an increase in the value of the domestic currency.
Effects of Currency Appreciation on Imports
Currency appreciation means a rise in the price of domestic currency (₹) in comparison to foreign currencies ($). Earlier, for example, an Indian resident needs ₹64 to buy a unit of dollar, but now he needs ₹60 to buy the same. It means that more goods can be purchased from the USA with the same amount of rupees in dollars. Thus, it leads to an increase in imports from the USA to India as American goods become cheaper.
Different countries have different methods of determining their currency’s exchange rate. It can be a Fixed exchange rate, Floating exchange rate or Managed Floating exchange rate.
Types of Foreign Exchange Rates
The three types of exchange rates are:
1. Fixed Exchange Rate
Under this system, the exchange rate for the currency is fixed by the government. Thus the government is responsible to maintain the stability of the exchange rate. Each country maintains the value of its currency in terms of some ‘external standard’ like gold, silver, another precious metal, or another country’s currency.
- The main purpose of a fixed exchange rate is to maintain stability in the country’s foreign trade and capital flows.
- The central bank or government purchases foreign exchange when the rate of foreign currency rises and sells foreign exchange when the rates fall to maintain the stability of the exchange rate.
- Thus government has to maintain large reserves of foreign currencies to maintain a fixed exchange rate.
- When the value of one currency(domestic) is tied to another currency, then this process is known as pegging, and that’s why the fixed exchange rate system is also referred to as the Pegged Exchange Rate System.
- When the value of one currency(domestic) is fixed in terms of another currency or in terms of gold, then it is called the Parity Value of currency.
Methods of Fixed Exchange Rate in Earlier Times
1. Gold Standard System (1870-1914): As per this system, gold was taken as the common unit of parity between the currencies of different countries. Each country defines the value of its currency in terms of gold. Accordingly, the value of one currency is fixed in terms of another country’s currency after considering the gold value of each currency.
1£(UK Pound)= 5g of gold
1$(US Dollar)= 2g of gold
then the exchange rate would be £1(UK Pound) = $2.5(US Dollar)
2. Bretton Woods System (1944-1971): The gold standard system was replaced by the Bretton Woods System. This system was adopted to have clarity in the system. Even in the fixed exchange rate, it allowed some adjustments thus it is called the ‘adjusted peg system of exchange rate’. Under this system:
- Countries were required to fix their currency against the US Dollar($).
- US Dollar was assigned gold value at a fixed price.
- The value of one currency say £(UK Pound) was pegged in terms of the US Dollar($), which ultimately implies the value of the currency in gold.
- Gold was considered an ultimate unit of parity.
- International Monetary Fund (IMF) worked as a central institution in controlling this system.
This is the system that was abandoned and replaced by the Flexible Exchange rate in 1977.
Fixed Exchange Rate has been discontinued because of many demerits of the system by all leading economies, including India.
2. Flexible Exchange Rate System
Under this system, the exchange rate for the currency is fixed by the forces of demand and supply of different currencies in the foreign exchange market. This system is also called the Floating Rate of Exchange or Free Exchange Rate. It is so because it is determined by the free play of supply and demand forces in the international money market.
- Under the Flexible Exchange Rate system, there is no intervention by the government.
- It is called flexible because the rate changes with the change in the market forces.
- The exchange rate is determined through interactions of banks, firms, and other institutions that want to buy and sell foreign exchange in the foreign exchange market.
- The rate at which the demand for foreign currency is equal to its supply is called the Par Rate of Exchange, Normal Rate, or Equilibrium Rate of Foreign Exchange.
3. Managed Floating Exchange Rate
It is the combination of the fixed rate system (the managed part) and the flexible rate system (the floating part), thus it is also called a Hybrid System. It refers to the system in which the foreign exchange rate is determined by the market forces and the central bank stabilizes the exchange rate in case of appreciation or depreciation of the domestic currency.
- Under this system, the central bank acts as a bulk buyer or seller of foreign exchange to control the fluctuation in the exchange rate. The central bank sells foreign exchange when the exchange rate is high to bring it down and vice versa. It is done for the protection of the interest of importers and exporters.
- For this purpose, the central bank maintains the reserves of foreign exchange so that the exchange rate stays within a targeted value.
- If a country manipulates the exchange rate by not following the rules and regulations, then it is known as Dirty Floating.
- However, the central bank follows the necessary rules and regulations to influence the exchange rate.
Example of Managed Floating Exchange Rate
Suppose, India has adopted Managed Floating System and the Reserve Bank of India (Central Bank) wants to keep the exchange rate $1 = ₹60. And let’s assume that the Reserve Bank of India is ready to tolerate small fluctuations, like from 59.75 to 60.25; i.e., .25.
If the value remains within the above limit, then there is no intervention. But if due to excess demand for the Indian rupee the value of the rupee starts declining below 59.75/$. Then, in that case, RBI will start increasing the supply of rupees by selling the rupees for dollars and acquiring holding of dollars.
Similarly, due to the excess supply of the Indian rupee, if the value of the rupee starts increasing above 60.25/$. Then, in that case, RBI will start increasing the demand for Indian rupees by exchanging the dollars for rupees and running down its holding of dollars.
Hence, in this way, the Reserve Bank of India maintains the exchange rate.