The chapter on Foreign Exchange Rate explains how currencies are valued, how foreign exchange markets operate, and how exchange rate systems affect an economy.

Meaning of Foreign Exchange Rate

A foreign exchange rate is the price of one country’s currency in terms of another currency.
For example, if 1 USD = ₹80, it means 1 US dollar can be exchanged for 80 Indian rupees.

Foreign exchange (forex) refers to all currencies other than the domestic currency. The foreign exchange market facilitates the buying and selling of these currencies.

Demand for Foreign Exchange

Demand for foreign currency arises when residents of a country need to make payments abroad. Major sources include:

• Imports of goods and services
  (e.g., India buying machinery from the USA)

• Foreign investment
  (Indians investing in foreign companies or stocks)

• Tourism or travel abroad

• Remittances sent to foreign relatives

• Payment of international debts or interests

Demand for foreign exchange is inversely related to the exchange rate:
When the foreign currency becomes expensive (e.g., USD becomes costlier in rupees), the demand for it falls.

Supply of Foreign Exchange

Supply of foreign exchange refers to the inflow of foreign currency into the domestic economy. It arises from:

• Exports of goods and services

• Foreign tourists visiting the country

• Foreign investment in domestic assets

• Remittances received from abroad

• Foreign loans and aid

Supply of foreign exchange is directly related to the exchange rate:
If foreign currency becomes more valuable, foreigners find domestic goods cheaper, increasing exports and thus increasing foreign exchange supply.

Determination of Exchange Rate

Under a flexible exchange rate system, the exchange rate is determined by the interaction of demand and supply of foreign exchange.

• If demand > supply, the foreign currency becomes costlier → domestic currency depreciates.

• If supply > demand, the foreign currency becomes cheaper → domestic currency appreciates.

The equilibrium exchange rate is where the demand for foreign exchange equals its supply.

Types of Exchange Rate Systems

1. Fixed Exchange Rate System

• The government or the central bank fixes the value of the currency.

• The exchange rate is kept stable.

• To maintain the rate, the central bank buys or sells foreign currency.

• Example: Under the Bretton Woods System (historical).

2. Flexible (Floating) Exchange Rate System

• The exchange rate is determined by market forces: demand and supply.

• No direct intervention by the central bank.

• May cause fluctuations depending on economic conditions.

3. Managed Floating Exchange Rate

• A mix of both systems.

• The exchange rate is mainly market-driven.

• The central bank intervenes only to reduce excessive volatility.

• India follows this system.

Depreciation and Appreciation

• Depreciation: Fall in the value of domestic currency in a flexible system (e.g., ₹75 → ₹80 per USD).

• Appreciation: Rise in the value of domestic currency (e.g., ₹80 → ₹75 per USD).

Devaluation and Revaluation

• Devaluation: Official reduction in the value of domestic currency under a fixed exchange rate system.

• Revaluation: Official rise in the value of domestic currency.

Foreign Exchange Market

This is the market where currencies are traded. It includes:

• Commercial banks

• Foreign exchange brokers

• Central banks

• Financial institutions

• Individuals and firms dealing with international trade

It ensures smooth international transactions by allowing currency conversion.

Importance of Exchange Rate

Exchange rates have a major impact on:

• International trade (exports and imports)

• Foreign investment flows

• Balance of payments

• Domestic inflation and interest rates

• Overall economic stability

A stable exchange rate helps businesses plan better and boosts investor confidence.