Class 12 Macro Economics Notes · CBSE

Foreign Exchange Market

Definition and functions of the foreign exchange market (transfer, credit, hedging), spot vs forward markets, other exchange rate systems (adjustable peg, wider band, crawling peg), and effective exchange rates NEER and REER. CBSE Class 12 Macroeconomics notes.

Notes

What is the Foreign Exchange Market?

The Foreign Exchange Market is where foreign currencies are bought and sold. Participants include individuals, firms, foreign exchange brokers, commercial banks, and the central bank. It is a global system rather than a single physical location, facilitating the trading, conversion, and exchange of numerous foreign currencies.

Participants

Individuals
Firms
Foreign exchange brokers
Commercial banks
Central bank

Functions of Foreign Exchange Market

Transfer Function

It enables the transfer of purchasing power between countries involved in international transactions. This is achieved through various credit instruments like bills of foreign exchange, bank drafts, and electronic transfers.

Credit Function

It provides credit necessary for international trade. Bills of exchange with typical maturity periods of three months are often used for international payments. This credit period allows importers time to receive, sell the goods, and obtain funds to settle the bill.

Hedging Function

Hedging involves exporters and importers agreeing to future transactions at current prices and exchange rates. The purpose is to protect against potential losses caused by unfavorable fluctuations in exchange rates between the time the contract is made and the transaction is settled.

Kinds of Foreign Exchange Markets

Spot Market vs Forward Market
Aspect	Spot Market	Forward Market
Settlement	Receipts and payments are made almost immediately (typically within two business days).	Buying and selling are agreed upon today but settled on a specific future date at a predetermined rate.
Exchange Rate	Spot exchange rate (current rate of exchange).	Forward exchange rate (agreed upon in advance).
Purpose	Deals with current transactions, not future ones.	Useful for international transactions agreed upon now but completed later.
Primary Uses	Immediate currency conversion for trade, tourism, etc.	Hedging (minimizing risk from adverse exchange rate changes) and speculation (profiting from expected rate movements).

Other Exchange Rate Systems

Adjustable Peg System

In this system, member countries fix their currency's exchange rate against a specific currency (often a major one) for a set period. However, the fixed rate can be adjusted (devalued or revalued) by the government under certain circumstances before the period ends.

Wider Band System

This system allows a country to change its currency's exchange value within a broader range, typically up to 10 percent, around a central parity value. This flexibility helps countries adjust their balance of payments.

Example

A country with a balance of payments deficit might depreciate its currency by up to 10% from its parity value to correct the imbalance.

Crawling Peg System

This system is a blend of managed floating and adjustable peg. A country sets a central parity value for its currency but allows small, regular adjustments (e.g., plus or minus a small percentage) around this parity. The parity rate itself is also adjusted periodically based on factors like international reserves, money supply changes, and price levels.

Effective Exchange Rate

Effective Exchange Rate (EER)

The Effective Exchange Rate (EER) is a measure of the average relative strength of a given currency compared to a group or basket of other currencies.

Nominal Effective Exchange Rate (NEER)

This measures the average relative strength of a currency against others without accounting for changes in price levels (inflation) in the respective countries. It is a weighted average of bilateral exchange rates.

Real Effective Exchange Rate (REER)

This is the Nominal Effective Exchange Rate (NEER) adjusted for the inflation differential between the domestic country and its trading partners. REER provides a more accurate picture of a currency's competitiveness by reflecting changes in purchasing power.

Key Distinction

NEER is a raw average — it doesn't account for inflation differences. REER adjusts for inflation, making it a truer measure of a currency's purchasing power and competitiveness in international trade.