Page 1 :
ECONOMICS, CHAPTER : 18, FOREIGN EXCHANGE RATE, , 1.Explain :, (i) Fixed Exchange rate, (ii) Flexible Exchange rate, (iii) Devaluation of currency, (iv) Depreciation in currency, (v) Appreciation of currency, (vi) Revaluation of currency, Answer : (i) Fixed Exchange Rate : It is a, system in which the central authority or, government maintains their exchange rate fixed, either against gold or some other currency. Fixed, exchange rate has two important types:, (a) Gold standard: Under gold standard, a, country’s Central Bank fixes its currency against, certain quantity of gold., (b) Bretton woods system: Under this system,, Central Bank ties its currency with USD, as the, official reserve asset.

Page 2 :
(ii) Flexible or Floating Exchange rate : The rate, of exchange which is determined by the market, forces of demand and supply of foreign currencies, in the foreign exchange market, is termed as a, flexible or floating exchange rate system., (iii) Devaluation of currency : Devaluation is the, fall in the value of domestic currency in relation to, foreign currency as planned by the Central Bank in, a situation when exchange rate is not determined, by forces of demand and supply under fixed, exchange rate system., (iv) Depreciation of currency : Depreciation of, domestic currency occurs when the value of, domestic currency decreases in relation to the, value of foreign currency (under a flexible, exchange rate system), ., (v) Appreciation of currency :When the value of, domestic currency increases in relation to a foreign, currency due to demand and supply forces in the, free market, it is termed as appreciation of the

Page 3 :
domestic currency, (under flexible exchange rate, system.), (vi) Revaluation of currency : Revaluation is the, rise in the value of domestic currency in relation to, foreign currency as planned by the Central Bank in, a situation when exchange rate is not determined, by market forces of demand and supply (under, fixed exchange rate system.), , 2. Explain with a diagram the determination of, foreign exchange rate in the free market., Answer :, (a) Exchange rate in a free exchange market is, determined at a point, where demand for foreign, exchange is equal to the supply of foreign, exchange., (b) Let us assume that there are two countries –, India and U.S.A – and the exchange rate of their, currencies i.e., rupee and dollar is to be, determined. Presently, there is a floating or flexible, exchange regime in both India and the U.S.A., Therefore, the value of currency of each country in

Page 4 :
terms of the other currency depends upon the, demand for and supply of their currencies., (c) In the above diagram, the price on the vertical, axis is stated in terms of domestic currency (that, is, how many rupees for one US dollar). The, horizontal axis measures the quantity demanded, or supplied., (d) In the above diagram, the demand curve [D$] is, downward sloping. This means that less foreign, exchange is demanded as the exchange rate, increases. This is due to the fact that the rise in, price of foreign exchange increases the rupee cost, of foreign goods, which make them more, expensive. As a result, imports decline. Thus, the, demand for foreign exchange also decreases., (e) The supply curve [S$] is upward sloping which, means that supply of foreign exchange increases, as the exchange rate increases

Page 5 :
This makes home country’s goods become, cheaper to foreigners since rupee is depreciating, in value. The demand for our exports should, therefore increase as the exchange rate increases., The increased demand for our exports translates, into greater supply of foreign exchange. Thus, the, supply of foreign exchange increases as the, exchange rate increases.