Inside the Foreign Exchange Market:

The Foreign Exchange Market, often referred to as the Forex or FX market, is the global marketplace where currencies are bought and sold. It serves as the cornerstone of international trade and finance, enabling the exchange of one currency for another. 

Participants in the Forex market include governments, banks, corporations, and individual traders, making it the largest and most liquid financial market in the world.

What factors influence Foreign Exchange rates in the forex market?

In the realm of global economics, exchange rate systems play a pivotal role in shaping trade and financial interactions among nations. 

• Definition: Foreign Exchange Rate(also called Forex Rate) is the price of one currency in terms of another.
• The Role of Exchange Rates: It links the currencies of different countries and enables comparisons of international costs and prices.
• Example: If we have to pay Rs 50 for $1 then the exchange rate is Rs 50 per dollar.
• Key Participants: Major players in the foreign exchange market include commercial banks, foreign exchange brokers, other authorised dealers, and monetary authorities. 
• Types of Exchange Rate: These are divided into fixed, flexible, and managed floating. 
• Fixed systems have government-set rates, maintained through foreign exchange reserves. 
• Flexible systems allow market-driven rates, providing automatic balance of payment adjustments. 
• Managed floating systems are hybrids, permitting central bank interventions to moderate rate fluctuations. 
• Factors Influencing Exchange Rate: 
• • Short-term rate changes often arise from interest rate differentials and income variations,
  • While long-term predictions use the Purchasing Power Parity theory to suggest rate adjustments for price equalisation across countries. 
• Each system impacts global trade, investment, and economic policies differently.

How does Global Connectivity shape the worldwide nature of the Foreign Exchange Market?

• Although participants may have their own trading centers, the foreign exchange market is worldwide.
  • There is close and continuous contact between trading centers, allowing participants to deal in more than one market.
• Example: 
  • An Indian resident planning a vacation to London would need to acquire pounds to pay for services during her stay.
  • She would need to know where to obtain the pounds and the exchange rate to calculate the cost in her native currency.

Demand for Foreign Exchange market and Its Impact on Costs:

• Purposes: Individuals and entities demand foreign exchange for purchasing goods and services from other countries, sending gifts abroad, acquiring financial assets of a specific country etc.
• Impact of Exchange Rate: A rise in the price of foreign exchange will increase the cost (in terms of rupees) of purchasing a foreign good. 
  • This reduces demand for imports and hence demand for foreign exchange also decreases, other things remaining constant.

Supply of Foreign Exchange market: Factors and Impacts

The supply of foreign exchange in a home country originates from various channels including exports, which entail 

• Foreigners purchasing domestic goods and services, 
• Receipt of gifts or transfers from foreigners and
• Foreigners buying assets in the home country.
• A rise in the price of foreign exchange: It will reduce the foreigner’s cost (in terms of USD) while purchasing products from India, other things remaining constant. 
  • This increases India’s exports and hence supply for foreign exchange may increase (whether it actually increases depends on a number of factors, particularly elasticity of demand for exports and imports.

Determination of the Exchange Rate in the Foreign exchange market:

• Different countries have different methods of determining their currency’s exchange rate. 
  • It can be determined through a Flexible Exchange Rate, Fixed Exchange Rate or Managed Floating Exchange Rate.

Flexible Exchange Rate Mechanism in the Foreign exchange market:

• A Flexible Exchange Rate: It is also known as a Floating Exchange Rate, is determined by market forces of demand and supply.
  • The exchange rate is established at the point where the demand curve intersects with the supply curve, as illustrated in Figure.
  • In a completely flexible system, Central Banks do not intervene in the foreign exchange market.

Impact of increased demand on Exchange Rate in the Foreign exchange rate:

• An increase in demand for foreign goods and services, for instance, due to increased international travel by residents, shifts the demand curve upward and to the right in the Foreign exchange market. 
  • This shift results in a change in the exchange rate, as depicted in Figure.

Exchange Rate Changes: Depreciation and Appreciation

• Initially, the exchange rate e0​=50 implies exchanging Rs 50 for one dollar.
• At the new equilibrium, the exchange rate becomes e1​=70, indicating a need to pay more rupees for a dollar, i.e., Rs 70.
• Depreciation: The increase in the exchange rate signifies a Depreciation of the domestic currency (rupees) in terms of the foreign currency (dollars) as the price of foreign currency (dollar) in terms of domestic currency (rupees) has increased.
• Appreciation: In a flexible exchange rate regime, when the price of domestic currency (rupees) in terms of foreign currency (dollars) increases, it is termed an appreciation of the domestic currency (rupees) in terms of foreign currency (dollars). 
• • This implies that the value of rupees relative to the dollar has risen, requiring fewer rupees in exchange for one dollar.

Speculation and its Impact on the Foreign Exchange Market

• Anticipated Impact: The expectation of currency appreciation plays a crucial role in the foreign exchange market. 
  • For instance, if Indians anticipate the British pound’s value will increase relative to the rupee, they may opt to hold pounds.
• Practical Example: Assuming the current exchange rate is Rs. 80 to a pound and investors predict that the pound will appreciate to Rs. 85 by the end of the month, they might purchase pounds at Rs. 80, expecting to profit later. 
  • Buying 1000 pounds for Rs. 80,000, they could sell them for Rs. 85,000, realizing a profit of Rs. 5,000.
• Impact on Exchange Rates: The expectation of currency appreciation enhances demand for that currency (in this case, pounds), causing the exchange rate to rise in the present. 
  • This rise in the exchange rate, driven by increased demand, can make the initial beliefs about currency appreciation self-fulfilling.

Interest Rates and the Exchange Rate in the Foreign exchange market:

• An Interest Rate: It is the amount a lender charges a borrower as a percentage of the principal amount. 
• An Exchange Rate: It is the rate at which one currency can be exchanged for another between nations or economic zones.
• Interest Rate Differential: the difference between interest rates between countries. 
  • In the short run, another factor that is important in determining exchange rate movements is the interest rate differential, i.e. Banks, multinational corporations, and wealthy individuals often move funds globally in search of the highest interest rates within the Foreign exchange market.
  • Example: If government bonds in country A offer an 8% interest rate, while equally safe bonds in country B yield 10%, the interest rate differential is 2%.

How do Interest Rates influence Exchange Rates in the Foreign exchange market?

• Attracting Investors: Higher interest rates in country B attract investors from country A, causing them to buy country B’s currency and sell their own. 
  • Conversely, investors in country B may find their higher interest rates more appealing, reducing their demand for country A’s currency.
• Exchange Rate Impact: Increased demand for country B’s currency and decreased demand for country A’s currency shift the demand curve for country A’s currency to the left and the supply curve to the right. 
  • This leads to the depreciation of country A’s currency and the appreciation of country B’s currency within the Foreign exchange market.

How does Income impact Exchange Rates in the Foreign exchange market?

• Interplay Between Income and Exchange Rates: Income levels impact exchange rates through consumer spending, imports, and exports, affecting the demand and supply curves for foreign exchange.
• Impact of Domestic Income Increase: An increase in income leads to higher consumer spending. 
  • Some of this spending is directed towards imported goods, increasing the demand for foreign exchange and resulting in the depreciation of the domestic currency.
• Impact of Foreign Income Increase: An increase in income abroad can boost domestic exports, shifting the supply curve of foreign exchange outward.

Relationship between Balance and Currency Depreciation in the Foreign exchange market:

• Net Effect on Currency: The net effect on the domestic currency’s value, whether it depreciates or not, depends on the growth rate of exports relative to imports. 
  • If exports grow faster than imports, it can offset the depreciation effect.
• Aggregate Demand Growth: A country experiencing faster aggregate demand growth compared to the rest of the world tends to see its currency depreciate. 
  • This is because its imports grow faster than exports, leading to a quicker shift in the demand curve for foreign currency compared to its supply curve.
  • Additionally, this phenomenon plays a crucial role in the foreign exchange market dynamics.

Long-Term Exchange Rate: Insights from the Foreign Exchange Market

• The Purchasing Power Parity (PPP) theory is employed to forecast long-term exchange rates under a flexible exchange rate system. 
  • It states that in the absence of trade barriers, exchange rates will adjust to equalise the cost of a given product across different countries.
  • Over an extended period, exchange rates between any two national currencies are expected to alter to mirror the disparities in the price levels existing in the two respective countries.
  • This intricate dance of exchange rates is intricately connected with the dynamics of the foreign exchange market, where global forces shape the equilibrium between currencies.

Understanding Fixed Exchange Rate Systems: Stability in the Foreign exchange market

• In a fixed exchange rate system, the government sets the exchange rate at a specific level, contrary to allowing market forces to determine it.
• This involves direct government or central bank intervention to maintain the fixed exchange rate.

Adjusting Exchange Rates: Government’s Strategic Role in the Foreign Exchange Market

• The government may alter the exchange rate to meet economic objectives. 
  • Example: To boost exports by making the domestic currency cheaper for foreigners, it might increase the exchange rate from Rs 50 to Rs 70 per dollar.
• The new government-set exchange rate is denoted as e1​, where e1​>e (market-determined rate).
• Government intervenes to maintain the exchange rate in foreign exchange market.

RBI Intervention in Foreign Exchange Market:

• Exchange Rate Discrepancy: When the new exchange rate (e1) results in an oversupply of dollars and surpasses the demand, the Reserve Bank of India (RBI) intervenes. 
  • RBI purchases the excess dollars with rupees in the foreign exchange market to maintain the desired exchange rate.
• Foreign Exchange Reserves Accumulation: This intervention (marked as AB in the figure) helps absorb the excess dollar supply but also leads to an accumulation of foreign exchange reserves as long as the intervention continues.

What are the consequences of inadequate Government Intervention in Exchange Rates and the Foreign exchange market?

• Exchange Rate at e2: If the government sets an exchange rate at a level such as e2, creating excess demand for dollars, it would need to utilize its dollar reserves to fulfill this demand.
• Black Market Emergence: Failing to do so could result in the emergence of a black market for dollars as individuals and businesses seek alternative, unofficial channels to obtain the needed foreign currency.
• Additionally, this situation highlights the importance of government intervention in the foreign exchange market.