UNIT - 4: EXCHANGE RATE AND ECONOMIC EFFECTS

INTRODUCTION
Currencies of different countries do not have the same value.
Example:
• ₹1 ≠ $1 ≠ €1 ≠ £1
Therefore, when countries engage in international trade,
foreign investment, tourism, lending & borrowing, etc.,
they need to exchange one currency for another.
Why do we need foreign currency?
• India imports crude oil from the USA → payment must
be made in USD.
 • Japan buys software services from India → payment
must be in INR.
• A foreigner invests in Indian stock market → must
convert foreign currency to INR.
Whenever transactions involve cross-border payments,
currency conversion takes place.
Thus, foreign exchange and exchange rate become
extremely important for international business.

EXCHANGE RATE
Meaning
Exchange Rate = Price of one currency expressed in terms of
another currency.
Example:
1 USD = ₹85 → means 1 Dollar can buy 85 Rupees.
Foreign currency transactions arise when:

Sl.
What causes foreign exchange transaction
No.
Buying/selling goods or services priced in a foreign
(a)
currency
Borrowing/lending funds when the payable/receivable
(b)
is in foreign currency
(c) Signing a forward exchange contract
Purchasing/selling assets or paying liabilities
(d)
denominated in foreign currency
So, whenever a business deals with foreign currency in any
form, the transaction is a foreign exchange transaction.

EXCHANGE RATE REGIMES

Governments adopt different systems to control currency
values. These systems are called exchange rate regimes.
There are three major systems:

Free / Floating Exchange Rate System

• Exchange rate is determined only by demand and
supply in the foreign exchange market.
• Government does not buy or sell currencies to
influence the rate.
Example:
If more people want USD than INR, USD appreciates & INR
depreciates.
Advantages

Advantage Explanation
Market automatically adjusts to shocks
Self-regulating
without government
Domestic market impact gets absorbed by
Shields economy
floating rate
Government can set interest/inflation
Independent
policies without worrying about
monetary policy
maintaining a fixed exchange rate

Disadvantages
 Disadvantage Explanation
High volatility Unpredictable movements create risk
Expensive for
Importers/exporters face uncertainty
trade
Businesses charge extra price to cover
Risk premium
exchange risk

Managed Floating Exchange Rate System

• Currency is basically free to float.
• Government/Central Bank occasionally intervenes to
reduce excessive volatility.
• They buy/sell foreign currency to influence exchange
rate.
Example:
If Rupee is falling sharply, RBI may sell USD from reserves
→ demand for USD reduces → stabilizes the Rupee.
→ Stable but flexible system.
→ Also called Dirty Float (because government secretly
intervenes).

Fixed Exchange Rate System

• Government fixes the currency value and does not
allow it to vary freely.
• Central bank must maintain foreign reserves to defend
the rate.
Example:
Government may declare → 1 USD = ₹50
To maintain this:
• If value tries to rise → govt sells rupees / buys dollars
• If value tries to fall → govt buys rupees / sells dollars
Advantages

Advantage Why important

Exchange rate Predictable — supports international
stability trade
Eliminates exchange Suitable for long-term contracts &
risks investment
Forces government to follow monetary
Controls inflation
discipline
Promotes investment Because currency remains stable
Helps commercial confidence in the
Enhances credibility
economy

Disadvantages
• Requires large foreign exchange reserves
• Reduces policy flexibility
• If the economy is weak, maintaining fixed rate becomes
impossible

NOMINAL VS REAL EXCHANGE RATE

Nominal Exchange Rate
• The exchange rate quoted in the market
• Does not consider price differences between countries.
Example:
1 USD = ₹85 → nominal rate
Real Exchange Rate
• Considers both nominal exchange rate and price levels
of both countries.
• Measures purchasing power of currencies.

Interpretation
• If RER increases → Domestic goods become costlier →
exports fall, imports rise
• If RER decreases → Domestic goods become cheaper
→ exports rise, imports fall
Real Effective Exchange Rate (REER)
• Weighted average of the real exchange rate compared
with multiple trading partners’ currencies.
• Shows whether a country is losing or gaining
international competitiveness.
→ If REER increases → exports become expensive →
competitiveness declines
→ If REER decreases → exports become cheaper →
competitiveness improves

FOREIGN EXCHANGE MARKET

A place where currencies of different countries are bought
and sold.
Key participants

Type Role
Commercial Banks Major traders of currencies
Exporters/Importers Need forex for trade
Investors Purchase foreign assets
Insurance / Pension funds Invest globally
Brokerage houses Act as dealers and market makers
Central banks Regulate the market

Types of market participants

Type Meaning
Active Players / Decide their own price quotes;
Market Makers influence the market
Passive Players / Use existing prices; do not
Market Users influence the market

Types of Foreign Exchange Transactions

 Type Meaning Settlement
Buy/sell currency for Within 2
Spot Transactions
immediate delivery days
Buy/sell currency at a
Forward / Futures
future date at a In future
Transactions
predetermined rate

Forward Premium / Discount

• Forward rate > Spot rate → Forward Premium
• Forward rate < Spot rate → Forward Discount

DETERMINATION OF NOMINAL EXCHANGE RATE

Exchange rate is determined through demand and supply of
foreign currency.
Demand for foreign currency arises because people want
to:
• Import goods/services
• Send donations/gifts abroad
• Pay interest/income abroad
• Buy foreign stocks/bonds
• Tour / study abroad
• Speculate in foreign currency
Supply of foreign currency arises because:
• Export earnings
• Foreign investment inflows
• NRI remittances
• Tourism in India
• Income from foreign assets
 • Foreign loans

Like any market:

• Demand curve slopes downward
• Supply curve slopes upward
• Intersection = equilibrium exchange rate

(For Revision)

Concept Key Meaning

Floating Market only decides

Market + Occasional government
Managed Floating
control
Fixed Government fixes currency rate

Nominal Rate Market quoted value

Real Rate Purchasing power–adjusted rate

Concept Key Meaning

REER Competitiveness indicator

Spot Transaction Immediate exchange

Forward Transaction Future exchange

Changes in Exchange Rates – Appreciation &

Depreciation
Exchange rate = how much of our currency you need to get 1
unit of foreign currency.
Example: 1 $ = ₹70

When does a currency depreciate?

Depreciation = value falls in terms of other currencies.
Example :
• January: 1 $ = ₹70
• April: 1 $ = ₹75

Now to get the same 1 dollar you must pay ₹75 instead of
₹70.
So:
• Rupee has depreciated (become weaker).
• Dollar has appreciated (become stronger) in terms of
rupees.
You can remember:
More rupees per dollar = rupee weaker (depreciation).
Fewer rupees per dollar = rupee stronger (appreciation).
When does a currency appreciate?
Appreciation = value rises.
If exchange rate changes from 1 $ = ₹75 to 1 $ = ₹70:

• You now need less rupees to buy 1 dollar.

• Rupee has appreciated (stronger).
• Dollar has depreciated in terms of rupees.

Home-Currency Depreciation & Appreciation with

Demand–Supply
Think of the foreign exchange market like any normal market.
• Demand curve (D) for dollars: Indians who want dollars
(for imports, travel, etc.)
• Supply curve (S) of dollars: foreigners who earn rupees
(from our exports, tourism to India, etc.) and want to
convert them into dollars.
(A) Home-currency depreciation
Initial equilibrium at point E:
• Exchange rate = eₑq (say, 1 $ = ₹70)

Now demand for dollars increases. Why?

• People import more,
• More Indians travel abroad,
• More demand to invest abroad, etc.
So demand curve shifts right from D to D₁.
• New equilibrium at E₁
• Exchange rate rises from eₑq to e₁ (say from ₹70 to ₹75
per dollar)
Result:
• To buy 1 dollar you now need more rupees ⇒ rupee
depreciates.
• Foreign currency (dollar) becomes more expensive.
So:
Rightward shift of demand for foreign currency → higher
exchange rate → home currency depreciates.
(B) Home-currency appreciation
Initial equilibrium again at E:
• Exchange rate = eₑq (say, 1 $ = ₹75)

Now supply of dollars in India increases. Why?

• Our exports go up (foreigners need more rupees to pay
us),
• More foreign tourists come to India,
• More foreign investment comes into India, etc.
So supply curve shifts right from S to S₁.
• New equilibrium at E₁
• Exchange rate falls from eₑq to e₁ (say from ₹75 to ₹70
per dollar)
Result:
• We now need fewer rupees to buy 1 dollar ⇒ rupee
appreciates.
• Foreign currency becomes cheaper.
So:
Rightward shift of supply of foreign currency → lower
exchange rate → home currency appreciates.

Devaluation vs Depreciation and Revaluation vs

Appreciation
These four terms confuse everyone, so keep one key idea:
• Devaluation/Revaluation → done by
government/central bank under fixed rate system.
• Depreciation/Appreciation → automatic, by market
forces under floating rate system.
Devaluation
• Country follows a fixed or pegged exchange rate.
• Government/central bank officially lowers the value of
its currency.
• Example: Government changes rate from 1 $ = ₹70
to 1 $ = ₹80 by announcement.
• Purpose: make exports cheaper, reduce trade deficit, etc.
Revaluation
• Again, under fixed rate.
• Government/central bank officially increases the value
of its currency.
• Example: from 1 $ = ₹80 to 1 $ = ₹70 by official
decision.
Depreciation
• Country has a floating exchange rate (market-
determined).
 • Due to demand and supply, the currency loses value.
• Example: heavy demand for dollars → rate moves from
1 $ = ₹70 to 1 $ = ₹80 on its own.

Appreciation
• Under floating rate.
• Due to market forces, value of currency rises.
• Example: strong exports and capital inflows → rate
moves from 1 $ = ₹80 to 1 $ = ₹70.

Impacts of Exchange Rate Depreciation on Domestic

Economy
Your pages list many points; let’s simplify.
(i) On foreign trade pattern
• Exchange rate changes influence what a country exports
and imports, and how much.
• Depreciation (rupee weaker) usually:
o Boosts exports (our goods become cheaper to

foreigners),
o Reduces imports (foreign goods costlier to us).

(ii) On relative prices – simple number example

Suppose:
• Earlier: 1 $ = ₹65
• Now: 1 $ = ₹70 (rupee depreciates)

A foreign good that costs $1:

• Earlier price in India = ₹65
 • Now = ₹70 ⇒ more expensive.
An Indian export that earlier cost ₹650:
• In dollar terms at ₹65/$: $10
• At ₹70/$: $650 ÷ 70 ≈ $9.29 ⇒ cheaper for foreigners.
So depreciation:
• Imports become costlier,
• Exports become cheaper and more competitive.
(iii) On overall economic activity (growth)
• Because domestic goods become cheaper compared to
foreign goods:
o People may shift demand from imports to local

products.
o Exports rise.

• This increases production and income in the economy.

• So depreciation can be expansionary (helps growth),
provided:
o Our producers can actually increase output,

o World demand exists for our exports.

(iv) On export earnings & employment

• Exporters get more rupees for the same dollars.
• Export industries (especially labour-intensive ones like
textiles, leather, IT services) can grow.
• This can create more jobs and higher wages.
(v) On inflation (price level)
• In the short run, depreciation makes imports costlier:
o Petroleum, machinery, raw materials, etc.
 • These higher costs pass through to prices of many goods
⇒ imported inflation.
• So depreciation can increase inflation, especially if we
depend heavily on imports.
(vi) On government finances & current account
• If government has to pay interest on foreign-currency
debt, a weaker rupee means:
o For each dollar of interest, more rupees are needed.

• Current account deficit:

o If imports become very expensive and exports don’t

increase enough, the deficit may widen.

o But if exports rise strongly, the balance can

improve.
(vii) On companies with foreign-currency loans
• Indian companies that borrowed in dollars/euros but did
not hedge:
o Their loan repayment in rupees becomes bigger

when the rupee depreciates.

o Their interest and principal burden increases,

profits fall, share prices can be affected.

(viii) On government foreign-currency debt
• Countries with large foreign-currency government debt
face higher interest and repayment costs after
depreciation.
• India’s public debt in foreign currency is relatively small,
so the risk is lower compared to some other countries.
(ix) On planning & risk (forecasting difficulty)
 • Frequent and large exchange rate fluctuations make
financial planning hard:
o Exporters/importers don’t know future rupee value.

o Firms must spend money on hedging (forward

contracts, options) to manage risk.

(x) On foreign investment flows
• Exchange rate has become a major factor for FDI and
FII.
• If investors expect further depreciation, they may fear
loss when converting profits back to their own currency
⇒ less willing to invest.
• Stable and predictable exchange rates encourage foreign
investment.
(xi) Example with Russia & India (in your text)
Your page gives a recent example: India–Russia trade after
sanctions, using rupee–ruble settlements etc., to show how
exchange rate issues and choices of trading currency affect
trade flows and deficits.

Effects of Exchange Rate Appreciation (Currency

Stronger)
Now take the opposite situation: rupee appreciates.
(i) On exports and imports
• Exports: become more expensive to foreigners → export
quantity falls.
• Imports: become cheaper for us → import quantity
rises.
 • Net exports fall, which can hurt GDP growth.
(ii) Depends on business cycle
• If the economy is in recession (low demand,
unemployment high):
o Appreciation further reduces demand for domestic

goods (exports fall, imports rise),

o Unemployment and slowdown can worsen.

• If economy is booming with high inflation, some

appreciation might reduce overheating.
(iii) On inflation
• Appreciation makes imported goods (including raw
materials and oil) cheaper.
• This can:
o Reduce cost of production,

o Lower inflationary pressures.

• So appreciation often helps control inflation.

(iv) On competitiveness and innovation
• Domestic industries become less competitive abroad and
at home (cheap imports).
• However, to survive, firms may:
o Adopt better technology,

o Increase efficiency,

o Focus on higher-quality, innovation-driven

products.
(v) On current account and external debt
• Higher imports + lower exports → current account
deficit can worsen.
 • To finance this, country may need more foreign capital
(loans or investment), increasing vulnerability.
(vi) If appreciation is due to strong fundamentals
• If currency appreciates because the economy is
genuinely strong (high productivity, strong exports, low
inflation),
then loss of competitiveness is smaller and may be
offset by strength in other areas.

QUICK RECAP
1. Exchange rate – rate at which currency of one country is
exchanged for currency of another.

2. Direct quote (European quotation) – number of units

of domestic currency per 1 unit of foreign currency.
o Example: 1 $ = ₹83 (India’s usual way).

3. Indirect quote (American quotation) – number of units

of foreign currency per 1 unit of domestic currency.
o Example: ₹1 = $0.012.

4. Cross rate – exchange rate between two currencies

calculated through a third currency.
o If you know ₹–$ and €–$ rates, you can derive ₹–€.
5. Exchange rate regime – the system a country uses to
manage its currency:
o Fixed/pegged rate,

o Floating (market-determined),

o Managed float / dirty float (central bank

intervenes sometimes),
o Crawling peg, etc.

6. Floating rate – demand and supply of foreign currency

decide the rate. Central bank does not commit to a fixed
level, but may intervene occasionally.

7. Fixed rate – government/central bank announces and

maintains a particular rate, adjusting using foreign
exchange reserves or policy.

8. Real exchange rate – adjusts the nominal rate for price

levels (inflation) in two countries. Rough idea:
Real rate ≈ Nominal rate × (Domestic Price Index /
Foreign Price Index)
9. Real Effective Exchange Rate (REER) – real exchange
rate of a country’s currency against a basket of
currencies of its trading partners, weighted by trade
shares. Indicates overall competitiveness.
10. Foreign exchange market (forex market) –
network (mostly electronic) where currencies are bought
and sold. Includes banks, dealers, brokers, central banks,
firms, etc.

11. Arbitrage – earning profit by buying currency in a

market where it is cheap and selling where it is
expensive, with no risk and often very short-term.

12. Types of forex transactions:

o Spot: immediate delivery (usually two business
days).
o Forward/futures: agreement today to buy/sell
currency at a pre-fixed rate on a future date.

13. Determinants of exchange rate in floating system:

o Supply and demand for foreign currency due to
trade in goods/services,
o Capital flows (investment, loans),
o Expectations, speculation, interest rate differences,
etc.
14. Devaluation & depreciation effects –
o Devaluation: deliberate downward change by
central bank in fixed-rate system.
o It and depreciation:
▪ Make exports cheaper,

▪ Make imports dearer,

 ▪ Encourage domestic production,
▪ Improve trade balance (if response is strong).

o Appreciation does the opposite:

▪ Exports dearer, imports cheaper,

▪ Can hurt domestic industries,

▪ May worsen trade balance, though it can help

reduce inflation.