Foreign Exchange Market

The market of exchanging foreign currencies is called as Foreign Exchange Market. Commercial banks, Foreign Exchange brokers, other approved businessmen, monetary officers were the major dealers of foreign exchange market. Foreign exchange rate is the rate of exchange of currencies between different countries. Foreign exchange rate will connect currencies of different countries and helps to compare the expenditure and price on international basis.

Determination of Exchange Rate 

Every nation has a distinct methodology to decide it's currency's exchange rate. In an open economy, the determination of exchange rate is done mainly through three methods - Flexible Exchange Rate, Fixed Exchange Rate and Managed Floating Exchange Rate.

1. Flexible Exchange Rate

Flexible Exchange Rate is also known as Floating or Floating Exchange Rate. The exchange rate is determined based on supply and demand forces of market. The Central bank does not deal with determination of Flexible Exchange Rate. The rise of rate of foreign currency compared to domestic currency is termed as depreciation of domestic currency. Depreciation happens only when the exchange rate increases. In the system of Flexible Exchange Rate, if the rate of domestic currency is increased when compared to foreign currency, then it is termed as Appreciation of domestic currency. The other important factor that determine the exchange rate of market is Speculation. Buying foreign currency in the expectation of increase of currency value in future is called as Speculation. Speculation involves trading a financial instrument involving high risk, in expectation of significant returns. The motive is to take maximum advantage from fluctuations of exchange rate. The major factor that determines the short term exchange rate is flexible interest rate.

Purchasing Power Parity is the theory used for the long term prediction of flexible exchange rate condition. Purchasing Power Parity (PPP) is an economic theory of exchange rate determination. Purchasing Power Parity states that the exchange rates of two countries for long term will reflect the difference of price standards of both countries.

Merits of Flexible Exchange Rate

a. This system gives more flexibility to government.

b. There is no need of storing the foreign exchange reserve currency in large quantity.

c. The changes in exchange rate voluntarily solve the unbalanced state (deficit, surplus) of Balance of Payment.

d. It gives the freedom to government for implementing the financial policy.

2. Fixed Exchange Rate

In Fixed Exchange Rate System, government determine the exchange rate in a special level. Fixed Exchange Rate System is also known as Pegged Exchange Rate System. Fixed Exchange Rate is determined by the central bank of a country (In India, RBI is the Central Bank). If there is any change in exchange rate, then central bank will get involved in Market and bring it to early determined exchange rate. If the exchange rate of a country's currency is determined by the financial authority of that country, then it is called as Fixed Exchange Rate. If the government get involved in the Fixed Exchange Rate and increase the exchange rate (that is, decreasing the value of domestic currency), then it is called as devaluation. Also if the government decrease the exchange rate (that is, increasing the value of domestic currency), then it is called as revaluation.

Merits of Fixed Exchange Rate

a. Government can maintain the exchange rate at a fixed level.

b. If there is any deficit in Balance of Payment, government can fill up it by using the official reserve currency.

3. Managed Floating Exchange Rate

The combined activities of both Fixed Exchange Rate and Flexible Exchange Rate is called as Managed Floating Exchange Rate. This system is not working under the base of any official international understanding. In this system, both flexible rate and fixed rate will work at same time. Managed Floating Exchange rate is also called as Dirty Floating Rate. Here the exchange rate is controlled by the market and central bank together. When the need arises, central government can get involve and can buy or sale foreign currency. So that the official foreign currency reserve does not disappear.