Foreign Exchange Rate – CBSE Notes for Class 12 Macro Economics

 Foreign Exchange Rate:-

           The foreign exchange rate or simply exchange rate refers to the rate at which one currency is exchange for another. For example, the exchange rate between rupees and dollar refers to the numbers of rupees required to purchase a dollar. Thus, the exchange rate between rupees and dollar from the India's viewpoint is Rs 81.5 = $ 1.

Fixed Exchange Rate:-

         The fixed exchange rate refers to the exchange rate which remains fixed and where all exchange transactions take place at the exchange rate that is determined by the monetary authorities.

Merits of Fixed Exchange Rate:-

       The fixed exchange rate have the following merits-

1. The fixed exchange rate promotes International trade since it makes the prices of tradeable goods more predictable thus leading to faster growth of the economy.

2. The fixed exchange rate system encourages long-term capital flows in an economy as under such exchange rate system the investors are prepared to invest for long periods.

3. Since there is no fear of currency depreciation or appreciation under the fixed exchange rate system, speculative activities are controlled and prevented by the monetary authority.

Demerits of Fixed Exchange Rate:-

          The fixed exchange rate system have the following demerits -

1. Countries under this system are required to maintain huge reserve of foreign currencies to avoid devaluation. Countries with balance of payments deficits must have huge foreign exchange reserves to avoid devaluation which imposes a heavy burden on the economy.

2. This system requires complicated exchange control measures leading to the misallocation of the economy's resources.

3. It is difficult to sustain the fixed exchange rate system in the long-run balance of payments problems and fluctuations in the international commodity market.

Flexible Exchange Rate:-

               Flexible exchange rate refers to the exchange rate which is determined freely by the market forces of demand and supply without the intervention of the monetary authorities. 

Merits of Flexible Exchange Rate:-

1. Countries under this exchange rate system are not required to maintain high foreign exchange reserves.

2. Flexible exchange rate system eliminates the problem of depreciation and appreciation of currencies.

3. It leads to automatic adjustment of balance of payments. 

Demerits of Flexible Exchange Rate:-

1. Since under the flexible exchange rate system the exchange rate flactuates freely more often, there is uncertainty in trade and investment.

2. The exchange rate under this system being uncertain it discourage foreign investment.

3. It has an adverse affects on the economy of the country.

4. It leads to unnecessary capital movement due to fluctuating exchange rate.

Purchasing Power Parity:-

      Purchasing power parity refers to the purchasing power of the country's currency in terms of the other countries currency. It measures international comparison of income and standard of living.

Nominal Exchange Rate :-

        Nominal exchange rate refers to the price of foreign currency in terms of domestic currency.

Real Exchange Rate:-

     The term 'real exchange rate' is defined as the ratio of foreign prices of goods to their domestic prices. It is the measure of the relative prices of goods between countries. It is the measure of international comparison of income and standard of living.