The Foreign Exchange Market

It is the market in which national currencies are traded for one another. The rate at which the price of one currency is determined in terms of another is called the foreign exchange rate or forex rate.

Demand for Foreign Exchange:

• The demand for foreign exchange arises due to various reasons such as purchasing goods, sending gifts abroad or purchasing financial assets of a certain foreign 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 the demand for foreign exchange also decreases

Supply of Foreign Exchange: 

• Supply of foreign exchange arises due to the inflow of foreign currency flows into the home country  
• The reasons are exports by a country lead to an inflow of forex, 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 the supply of foreign exchange may increase

Determination of the Exchange Rate:

Various countries use different methods to determine the exchange rates. These methods are as follows: 

Flexible Exchange: 

• It is also known as the floating exchange rate

• Under this system, the exchange rate is determined by the market forces of demand and supply

• In a completely flexible system, the Central banks do not intervene in the foreign exchange market
• An increase in the exchange rate implies that the price of foreign currency (dollar) in terms of domestic currency (rupees) has increased and vice-versa
• When the price of domestic currency (rupee) in terms of foreign currency (dollar) decreases, it is called the depreciation of the domestic currency
• Similarly, when the price of domestic currency (rupees) in terms of foreign currency (dollars) increases, it is called appreciation of the domestic currency
• In a flexible exchange regime, the market determines the currency exchange rate
• The exchange rate is typically determined at the equilibrium point on the demand and supply curve
• More demand for foreign goods may increase the exchange rate because more domestic currency has to be paid in order to obtain a unit of foreign currency

Fixed Exchange Rates:

• In this system, the Government fixes the exchange rate at a particular level
• The government can maintain any exchange rate in the economy
• But it will be accumulating more and more foreign exchange so long as this intervention goes on
• Devaluation: It makes the domestic currency cheaper for foreigners by fixing a higher exchange rate than the current one
• It is done to encourage exports
• Revaluation: When the government decreases the exchange rate (thereby, making domestic currency costlier) in a fixed exchange rate system

Demerits and Merits of Flexible and Fixed Exchange Rate Systems:

Demerits of Fixed Exchange Rate System:

• In order for this system to work, there must be credit that the government will be able to maintain the exchange rate at the level specified 
• In case of a deficit in BoP, governments will have to intervene to take care of the gap by use of their official reserves
• In case people learn that the amount in these reserves is insufficient to do so they would begin to doubt the ability of the government to maintain the fixed rate 
• This may give rise to speculation of a devaluation
• When this belief translates into aggressive buying of one currency thereby forcing the government to devalue, 
• It is said to constitute a speculative attack on a currency
• Fixed exchange rates are prone to these kinds of attacks

Managed Floating Exchange Rate System: 

• It is also known as a dirty floating exchange rate
• It is a mixture of a flexible exchange rate system (the floating part) and a fixed rate system (the managed part)
• In this exchange rate regime, RBI intervenes in the market to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate
• Official reserve transactions are, therefore, not equal to zero

Conclusion 

A new approach to managing exchange rates is called the Liberalized Exchange Rate Management System, or LERMS for short. 40% of export and inbound remittance profits were acquired by RBI for official use at the official exchange rate under this scheme. It was adopted in accordance with the C. Rangarajan Committee’s recommendations, which included a dual exchange rate.