Foreign exchange

It is the rate, at which domestic currency is exchanged for foreign currency. For Example 1$= 70 Indian Rupee.

Exchange rate system can be constituted as:

1. Fixed Exchange rate system
2. Flexible Exchange rate system

Fixed Exchange rate system

Under the fixed exchange rate system, the rate of exchange is fixed by the government. The purpose of the fixed rate system is to keep the currency value within a limit. A fixed exchange rate is a type of exchange rate system where the value of a country’s currency is directly tied or fixed to the value of another major currency or a basket of currencies. In a fixed exchange rate system, the government or central bank of a country actively intervenes in the foreign exchange market to maintain the currency’s value within a narrow band or at a specific rate against the chosen reference currency or currencies.

Examples: The gold standard is a historical example of a fixed exchange rate system, where currencies were directly pegged to a specific quantity of gold. Another example is the Bretton Woods system, where major currencies were pegged to the U.S. dollar, and the U.S. dollar was convertible to gold.

It’s worth noting that many countries have moved away from fixed exchange rate systems in favor of floating exchange rates or other arrangements due to the challenges and limitations associated with maintaining fixed rates in a dynamic global economy.

Flexible Exchange rate system

A flexible exchange rate system, also known as a floating exchange rate system, is a type of exchange rate arrangement in which the value of a country’s currency is determined by market forces such as supply and demand in the foreign exchange market. In this system, exchange rates are allowed to fluctuate freely based on economic conditions without direct government or central bank intervention to maintain a specific value.

Here are some key features and characteristics of a flexible exchange rate system:

1. Market Forces: Under a flexible exchange rate system, the exchange rate is primarily determined by market forces. The forces of supply and demand in the foreign exchange market influence the value of a currency relative to other currencies.
2. Independence: Governments and central banks do not actively intervene in the foreign exchange market to stabilize or control the value of their currency. Exchange rates are left to adjust based on economic fundamentals.
3. Adjustment Mechanism: Flexible exchange rates serve as an automatic adjustment mechanism. If a country experiences economic changes, such as inflation or changes in interest rates, the exchange rate will adjust to reflect these shifts in economic conditions.
4. Market Participants: Participants in the foreign exchange market, including banks, financial institutions, corporations, and individual traders, play a significant role in determining exchange rates through their transactions.
5. Volatility: Compared to fixed exchange rate systems, flexible exchange rate systems can exhibit higher short-term volatility. Exchange rates can experience frequent fluctuations based on various economic and geopolitical factors.
6. Monetary Policy Autonomy: Countries with flexible exchange rates have more autonomy in conducting their own monetary policies. They can independently set interest rates and adjust monetary conditions without the constraint of maintaining a fixed exchange rate.
7. Trade Balances: Changes in exchange rates can impact a country’s trade balance. A depreciation of a currency can make exports more competitive and imports more expensive, potentially improving the trade balance.
8. Global Economic Conditions: Exchange rates in a flexible system are influenced by a wide range of factors, including economic indicators, interest rates, inflation, political stability, and global economic conditions.
9. Examples: Many major currencies, including the U.S. dollar (USD), the Euro (EUR), and the Japanese Yen (JPY), operate under a flexible exchange rate system. These currencies are freely traded in the foreign exchange market, and their values are determined by market dynamics.

While flexible exchange rates offer greater autonomy and adaptability to changing economic conditions, they can also pose challenges, including exchange rate volatility and uncertainty for businesses engaged in international trade. Central banks may still intervene in the foreign exchange market occasionally to stabilize extreme fluctuations or address disruptive market conditions.

Demand for foreign exchange

There are some purposes, why foreign exchange is demanded. Regarding which, the followings can be the reasons:

1. Payments of international loans
2. Gifts and grants to rest of the world
3. Investment in rest of the world

Supply of foreign exchange

When or why foreign currency flows from one country to another country, following reasons can be given:

1. Export from the country to the rest of the world.
2. Direct foreign investment.
3. Direct Portfolio investment.
4. Remittances by the non-residence living in the foreign country.

Foreign exchange market

Foreign exchange market refers to the market where national currency of different countries is exchanged. It resembles any other market where buyers and sellers meet and conduct buy and sell operations, only the subject of such transactions in foreign exchange market is foreign currency.

Function of foreign exchange market

1. Transfer function: It refers to the transfer of foreign currency to the rest of the world.

2. Credit function: It refers to the provision of credit in terms of foreign currency for export or import of goods and services to the different countries of the world.

3. Hedging function:  Hedging refers to taking a temporary position to offset the losses of   present cash position with future position. It provides protection against the risk caused from change in foreign exchange rate.