Class 12 Macro Economics Notes · CBSE

Understanding Foreign Exchange and Exchange Rate

Foreign exchange meaning, exchange rate as the price of one currency in terms of another, and currency depreciation and appreciation with effects on exports, imports, and national income. CBSE Class 12 Macroeconomics notes.

Notes

What is Foreign Exchange?

Foreign Exchange

Foreign Exchange refers to all currencies other than the domestic currency of a particular country. For example, for India, where the domestic currency is the Indian Rupee, currencies like the US Dollar, British Pound, and Kuwaiti Dinar are considered foreign exchange.

When an American firm exports goods to India, it expects payment in Dollars. This necessitates Indian importers converting Indian Rupees into American Dollars. This process raises the issue of converting one currency to another and establishing the rate at which this exchange occurs, which is the core problem of determining the foreign exchange rate.

All countries use their own distinct currencies within their borders — the Indian Rupee in India, the US Dollar in America, and the Pound in England. When international payments are made, the currency of one country must be converted into the currency of the other.

Foreign Exchange Rate — Meaning and Formula

Foreign Exchange Rate

Foreign Exchange Rate is defined as the rate at which one currency is exchanged for another. It essentially represents the price of one currency expressed in terms of another.

Exchange Rate Calculation

1 = \frac{1}{81} \$ \approx 0.0123 \$

Solved Example

Problem

If $1 = ₹81, what is the value of ₹1 in Dollars?

Solution

₹1 = 1/81 $ ≈ $0.0123

The foreign exchange rate quantifies the number of units of one currency needed to exchange for one unit of another. If the exchange rate between Pounds and Rupees is £1 = ₹105 or £1 : ₹105, it means one hundred and five rupees are required to obtain one pound. Exchange rates can change frequently, even daily. A country has as many foreign exchange rates as there are foreign currencies it trades with. Similar to other prices, the exchange rate is determined by the forces of demand and supply.

Currency Depreciation

Currency Depreciation is a decrease in the value of a country's domestic currency relative to a foreign currency. This makes the domestic currency less valuable, requiring more units of it to purchase a unit of foreign currency.

The Rupee depreciates if the price of $1 increases from ₹81 to ₹82.

A change from $5 = £4 to $4.5 = £4 indicates that the UK pound is depreciating relative to the US dollar.

Increase in Exports

When the domestic currency depreciates, its price falls in terms of a foreign currency. This means that with the same amount of dollars, more goods can be bought from the domestic country. Consequently, exports become relatively cheaper for foreign buyers, leading to an increase in exports.

Decrease in Imports

Depreciation makes foreign goods relatively more expensive for domestic buyers because they need to pay more domestic currency to import foreign goods. This leads to a fall in imports.

Increase in National Income

An increase in exports and a decrease in imports due to domestic currency depreciation result in an increase in Net Exports (Exports - Imports). Assuming other factors remain constant, this increase in Net Exports contributes to an increase in National Income.

The following statements are equivalent ways of saying that the domestic currency has depreciated:

Domestic or Home Currency has depreciated.
There is a fall in the price of Domestic Currency.
Domestic Currency has become less valuable.
Foreign Currency has become more valuable.
Exchange Rate of Domestic Currency falls.
There is a decrease in Exchange Rate of Home Currency.
Exchange Rate of Domestic Currency has become weaker.

Currency Appreciation

Currency Appreciation is an increase in the value of a country's domestic currency relative to a foreign currency. As the domestic currency becomes more valuable, fewer units of it are needed to purchase a unit of foreign currency.

The Indian Rupee appreciates when the price of $1 falls from ₹82 to ₹81.

A change from $4.5 = £4 to $5 = £4 indicates that the UK pound is appreciating relative to the US dollar.

Increase in Imports

Appreciation of the domestic currency means its price rises in terms of a foreign currency. Now, one unit of domestic currency can be exchanged for more foreign currency. With the same amount of domestic money, more foreign goods can be purchased. This makes foreign goods relatively cheaper for domestic buyers, leading to an increase in imports.

Decrease in Exports

Appreciation leads to a decrease in exports because one unit of foreign currency will now buy fewer domestic goods. This makes domestic goods relatively more expensive for foreign buyers, causing exports to fall.

Decrease in National Income

As exports fall and imports rise due to domestic currency appreciation, Net Exports decrease. Assuming other factors remain constant, this reduction in Net Exports will reduce National Income.

Depreciation vs Appreciation Comparison

Currency Depreciation vs Currency Appreciation
Aspect	Currency Depreciation	Currency Appreciation
Meaning	Refers to decrease in the value of domestic currency in terms of foreign currency.	Refers to an increase in the value of domestic currency in terms of foreign currency.
Effect on Imports/Exports	Makes domestic goods cheaper in foreign countries, leading to an increase in exports.	Makes foreign goods cheaper in the domestic country, leading to an increase in imports.
Example	A change from $1 = ₹81 to $1 = ₹82 represents that the Indian Rupee is depreciating.	A change from $1 = ₹82 to $1 = ₹81 represents that the Indian Rupee is appreciating.