HOW FOREIGN EXCHANGE RATE IS DETERMINED | FOREIGN EXCHANGE | FUNCTIONS OF FOREIGN EXCHANGE
Foreign
Exchange Markets
The
foreign exchange market is the market in which individuals’ firms
and banks buy and sell foreign currencies
for foreign exchange.
Functions
of the Foreign Exchange Market
Foreign exchange market performs different functions. They are as follow;
(1)
Transfer of funds.
(2)
Credit functions.
(3) Providence of facilities
for hedging and speculation.
Types
of Exchange Rate:
(1) Fixed Exchange Rate
Under
fixed exchange rate all exchange transactions take place at an
exchange rate that is determined
by the monetary authorities. The establishments may fix the exchange
rate by lawmaking or interference
in currency bazaars. They may buy or sell currencies according to
the needs of the country or may take policy decisions to appreciate
or depreciate the national
currency,
Advantages
of Fixed Exchange Rates:
(I
The cast for fixed exchange rates between different countries is based on the case for a common currency within a country. A country having a common currency
with a fixed value facilitates
trade, increases production and leads to faster growth of economy,
So, fixed
exchange rates
increase international trade. This
promotes economic integration.
(2)
It motivates
long term capital movements in an tidy and smooth method. There is no risk
involvement.
(3)
There is no fear of currency depreciation or appreciation under fixed
exchange rate system.
(4) There is no dread
of any adversative effect of assumption on the exchange rate.
(5) It serves as an anchor and
imposes a discipline on monetary
authorities to follow responsible
financial
policies within a country.
Disadvantages
of Fixed Exchange Rates:
(1)
The principal defect is the sacrifice of the objectives of full
employment and stable prices at the
altar of stable exchange rates for example a balance of payment adjustment under this
system can take place
only by rising in prices.
(2) Yet again, under this structure
the things of unforeseen turbulences
in the domestic economy are transformed
overseas.
(3)
Under this system large reserves of foreign currencies are required to
be maintained. Countries
with BOP deficits must have large reserves if they want to avoid
devaluation.
(4)
It requires complicated
exchange control measures
which leads to mall allocation of the
Economy’s
resources.
(5) Another problem relates to
the stability of exchange
rate. The exchange rate of a country vis a- Vis another country cannot
persist static for extended
time. BOP problems and
fluctuations in international
commodity prices often compel countries to bring changes in exchange rates.
(2) Floating or Flexible Exchange Rates
Floating
or flexible exchange rates are accumulated/calculated by market factors. Under a regime of freely
fluctuating exchange
rates, if there is
an excess of supply of money or currency,
the value of that currency in foreign exchange markets will fall. It will lead to depreciation of the exchange rate
consequently the equilibrium will be restored in the exchange market.
On the other hand. shortage
of currency will lead to the appreciation of exchange rate there by
leading to restoration of equilibrium
in the exchange market. These market factors function routinely
without any action on the chunk of monetary establishments.
Advantages
of Floating Exchange Rates:
1)
A system of flexible exchange rates is. simple in operation.
(2)
Under a system of flexible exchange rates, the adjustment is continual.
The adjustment in balance
pf payments is smoother and painless as compared with fixed
exchange rates.
(3)
Under flexible exchange rates,
autonomy of the domestic
economic policies is preserved. Contemporary governments are devoted to
preserve complete employment
and encourage steadiness with growth.
(4) Under a system of floating
exchange, rates disequilibrium
in BOP is automatically corrected.
(5)
There is no need of foreign exchange reserves where exchange rates are
moving freely.
(6)
When foreign exchange rates move freely, there is no to have international
institutional arrangements
like IMF for borrowing and lending short term loans.
(7) Flexible exchange rates reinforce
the effectiveness
of monetary policy.
(8) A system of flexible exchange
rates does not require
the introduction of complicated and expensive trade restrictions and
exchange controls.
(9) No need of forming custom
unions and currency areas.
Dis-advantages of Floating Exchange Rates:
(1)
Market mechanism may. fail to bring appropriate exchange rate.
(2)
Frequent variations in
exchange rates, create exchange
risks, breed uncertainty and
impede international
trade and capital
movements.
(3)
Major defect is that speculation adversely influences fluctuations in
supply and demand for foreign
exchange.
(4)
Another serious drawback of floating currency rate is the inflationary bias.
(5)
It breaks up the world market, there is no one money which serves as a
medium of exchange unit of
account, store of value and a standard of deferred payment.
(6)
It is difficult to define a freely flexible exchange rate. It is not possible
to have an exchange rate where
there is an absolutely no official interventions. Government might not arbitrate directly in the foreign exchange
market, but native
monetary and fiscal actions do effect
foreign exchange rates.
Determination
of Equilibrium Exchange Rate:
The
exchange rate in free market is determined by the demand for and supply
of foreign exchange. The equilibrium
exchange rate is the rate at which the demand and supply of foreign exchange are equal.
The
Demand for Foreign Exchange
The
demand for foreign exchange is a derivative demand from pounds. It
arises from imports of British goods
and services into the US and from capital movements from US to
Britain. Actually,
the demand for pounds
indicates a supply of dollars. When the US businessman by British goods and services and make capital transfers to Britain, they
create demand for British
pounds in exchange of US dollars because they cannot make payments to
Britain in their currency, the US
dollars.
Form
of the demand curve for foreign exchange will be contingent on the springiness
of demand for imports. If a country
imports necessities and raw materials, we may expect the elasticity of
demand for importers go be low and
the quantity imported to be insensitive to price changes. On other hand the
country imported luxury goods
for which suitable substitutes exist, demand elasticities for imports
might be high. If the country
has many mature import challenging industries, the elasticity
of demand for imports most surely
is high.
Supply
of Foreign Exchange:
The
supply of foreign exchange in our assumed case is the supply of
pounds. It ascends from the US exports
of goods and services and from capital arrangements. Pounds are offered in
exchange for dollars because
British boulders of pounds wish to make payment in dollars. Thus,
the supply of foreign exchange reflects
the quantities of pounds that would be supplied in the foreign exchange
market at various dollar prices of
pounds. Shape of the supply curve of foreign exchange will be
determined by the elasticity of the Supply curve.
Graphical
Representation:
Equilibrium
Exchange Rate:
Given
the demand and supply of foreign exchange the equilibrium exchange
rate is determined where DD the
demand curve for pounds intersects SS the supply curve of pounds. They cut each other at E.
Suppose
there is a shift upward in US demand for pounds to DD'. The reason
can be increase in US tastes for
British goods or increase in US national income. Which increases demand for imported goods in U.S. with shifting up dollar
depreciates and British pound appreciates
which reestablish new equilibrium exchange rate OR' at point E.
On
next hand, if supply of pounds increase and supply curve shifts down
from SS to SS' the value of pound
depreciates and that of a dollar appreciates. This brings new equilibrium
exchange rate OR’
at point E’. The supply of pounds
increases due to increase in teste of Britishers for US goods and
increase in national income
of Britain.
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