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1. Foreign Exchange It refers to the reserve of foreign currencies.
e.g. INR is Indian currency except that all other currency will be foreign exchange for India.
2. Foreign Exchange Rate It is the rate at which one currency can be exchanged for the other currency in the foreign exchange market, e.g.? 58 are to be paid to buy one dollar, then the t/ $ (Rupees per dollar) exchange rate is 58 i.e.? 58 per $.
3.Exchange Rate System
(i) Fixed exchange rate system It is a system in which the central authority or government maintains their exchange rate fixed either against gold or some other currency. The fixed exchange rate has two important types:
(a) Gold standard Under a gold standard, a country’s Central Bank fixes its currency against a certain quantity of gold.
(b) Bretton woods system Under this system, Central Bank ties its currency with USD, as the official reserve asset.
(ii) Flexible Exchange Rate System 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 a flexible exchange rate system. Flexible exchange rate system has two main types:
(a)Clean floating system Under this system, the exchange rate is freely determined by the market forces of demand and supply of foreign exchange with no interference by the central authority.
(b) Managed floating system Under this system, the exchange rate is determined by the market forces of demand and supply of foreign exchange, and the excessive fluctuation is checked by the central authority, it is also termed as dirty floating.
4. Merits of Fixed Exchange Rate System
(i) Minimise exchange rate fluctuations
(ii) Reduces volatility and fluctuations in prices
(iii)Imposes discipline on the monetary authority
(iv) Encourages international trade and investment flows
(v) Less speculation in the currency market
5. Demerits of Fixed Exchange Rate System
(i) Central Bank needs to hold huge stocks of either Gold or USD.
(ii) Do not allow for automatic stabilization of exchange rate.
(iii) Diverts Central Banks focus from economic problems to exchange rate
(iv) It discourages venture capital.
(v) There exist the possibility of policy delay.
6. Merits of Flexible Exchange Rate System
(i) Independent monetary policy
(ii) Encourages international mobility of capital and trade
(iii) Encourages venture capital
(iv) No need to maintain the huge stock of gold or other currency
7. Demerits of Flexible Exchange Rate System
(i) Creates the condition of instability in the international trade
(ii) Adverse effect on the economic structure
(iii) Unnecessary capital movements
(iv) Inflationary problems
(v) Difficulty in policy formation
8. Different Concepts of Foreign Exchange Rate
(i) Nominal exchange rate It refers to the number of units of domestic currency, one must give up to get a unit of foreign currency. In simple terms, it refers to the price of foreign currency in terms of the domestic currency.
(ii) Real exchange rate The real exchange rate is the ratio of foreign to domestic prices, measured in the same currency. It is defined as：
(iii) Nominal Effective Exchange Rate (NEER) It is that type of effective exchange rate which does not account for the change in price level while measuring the average strength of one currency about the other.
(iv) Real Effective Exchange Rate (REER) It is that type of effective exchange rate which accounts for changes in the price level across different countries of the world.
9. Sources of Demand for Foreign Exchange
(i) Payment of loans and interest to international organizations
(ii) Gifts and grants to the rest of the world
(iii) Foreign investment across the world
(iv)Foreign trade i.e. Imports
(v) Foreign exchange trade for speculation
(vi) Foreign tourism
10. Sources of the Supply of Foreign Exchange
(i) Exports of goods and services from domestic country
(ii) Foreign investment
(a) Foreign direct investment
(iii)Foreign tourism from abroad.
(iv)Purchases by non-residents in the domestic country.
(v) Remittances from abroad