Question

Write a short note on Foreign Exchange Rate. What are meant by Fixed and Flexible Exchange Rates ?

Hint:

To remember the terms: \begin{itemize} \item Fixed System: Changes are official and deliberate \(\to\) Devaluation (down) and Revaluation (up). \item Flexible System: Changes are market-driven \(\to\) Depreciation (down) and Appreciation (up). \end{itemize}

Answer 1

Part 1: Foreign Exchange Rate
The foreign exchange rate (or forex rate) is the rate at which one country's currency can be exchanged for another country's currency. It essentially represents the price of a foreign currency. For example, if the exchange rate between the US dollar and the Indian rupee is \$1 = Rs. 80, it means one US dollar can be bought for 80 Indian rupees.
The foreign exchange rate is a crucial economic variable as it facilitates international trade and investment. It links the economies of different countries by allowing for the comparison of prices and values across borders. Exchange rates are determined in the foreign exchange market, where currencies are bought and sold.
Part 2: Fixed Exchange Rate System
A fixed exchange rate system, also known as a pegged exchange rate system, is a regime where a country's government or central bank officially fixes its currency's exchange rate against another country's currency or a basket of currencies. \begin{itemize} \item Mechanism: To maintain this fixed rate (or "peg"), the central bank must intervene in the foreign exchange market. If the market rate tends to deviate from the fixed rate due to changes in demand or supply, the central bank buys or sells its own currency in exchange for foreign currencies. For instance, to prevent its currency from depreciating, the central bank will sell its foreign exchange reserves and buy its domestic currency. \item Devaluation and Revaluation: When the government officially lowers the exchange rate value of its currency, it is called devaluation. When it officially raises the value, it is called revaluation. \item Advantage: It provides stability and predictability in international trade and investment. \item Disadvantage: It requires the central bank to hold large reserves of foreign currency and can lead to a loss of control over domestic monetary policy. \end{itemize} Part 3: Flexible Exchange Rate System
A flexible exchange rate system, also known as a floating exchange rate system, is a regime where the value of a currency is determined purely by the market forces of demand and supply in the foreign exchange market, without any official government intervention. \begin{itemize} \item Mechanism: The equilibrium exchange rate is found at the point where the quantity of a currency demanded equals the quantity supplied. The demand for a currency arises from foreign demand for the country's exports and assets, while the supply arises from the country's demand for imports and foreign assets. \item Appreciation and Depreciation: If the demand for a currency increases, its value rises; this is called appreciation. If the demand falls (or supply increases), its value falls; this is called depreciation. \item Advantage: It automatically adjusts to correct deficits or surpluses in the balance of payments and allows the central bank to focus on domestic policy objectives. \item Disadvantage: It can be highly volatile, creating uncertainty for businesses involved in international trade. \end{itemize}