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Topic 20

Foreign Exchange - How Rates are Fixed

Everyone of us know what foreign exchange is and how it fluctuates everyday in rupees and paise. But very few of us ever think how the exchange rate is fixed first of all, between currencies of different nations.

Here, in very basic terms, I will try to explain how it is done.

First of all, it is clearly based upon supply demand theory in economics. I am not an economist and neither do I know much about it. But in my understandings the foreign exchange is nothing but a simple supply demand theory of economics applied between currencies of different nations.

I will try to explain it with a very simple example. Suppose you want to buy a Kg of rice. Why can't you buy that Kg for just one paisa or one rupee? Why do you have to pay Rs.20 or Rs.30 to buy that Kg of rice? Because your supplier or simply your shop keeper couldn't get it for that price. He has to buy that Kg of rice from a whole sale dealer for some price and then he will have to fix his own retial price adding profits to it.

So, now if the whole sale dealer has enough reserves of rice the price will reduce automatically, and if not, your supplier has to pay more to the whole sale dealer to get rice from somewhere else and sell it to you and so the cost will rise. So, what is affecting the price of rice is the reserve of the rice at the whole sale dealer. This reserve is a direct result of how well the agriculture sector has done in the current year in the country and how the imports have been into the country to meet the demands of the people if a particular commodity is not grown or available in this country.

So, now just try to compare this example with that of the economic sector of the country. You can realise that, you, are the customer, your supplier is your bank and the whole sale dealer is the Central Reserver Bank of the country. Now you can easily understand why different banks have different exchange rates. Different banks buy currency at different rates and add profits to that rate and sell at different rates.

Now, I will come to the actual point. How the actual currency exchange rate is fixed. The Central Reserve Bank of the country (in India it is the Reserver Bank of India, in England it is the Bank of England, in Scotland it is the Bank of Scotland, etc.) will always maintain reserves of foreign currency to supply the end user (banks) when demanded. So it is this reserve which decides the exchange rate. Suppose you want to buy a British Pound. You can buy that at the expense of around Rs.70 - Rs.80. So, why cannot you buy it for just one rupee?

Because, if you give one rupee to the Central Reserve Bank and demand it to give one British Pound in exchange, the reserve bank has to spend the other Rs.69 - Rs.79 on its own to buy one Pound from the bank of england, which it cannot, becaue if it does like that then soon the bank will go into bankruptcy as it will no longer have any reserve of the local currency.

So, the Central Reserve Bank calculates how much you have to pay for buying a single Pound basing on how much it has spent to buy a pound from the Bank of England. So, this depends on, how much of foreign currency reserve is presently stocked in the country and what is current demand and how much of the currency from this country is flowing in and how much of it is being exported to that country. This is what is called as Forex Market. Investors trying to invest in the country and goods being exported to the country in turn.

This imports and exports dictate the current stock of a particular currency in the country and how much the Central Reserve Bank has to spend in addition, to buy that currency from that country, if it doesn't meet its people's requirements. That extra money is what we pay from our pockets, the exchange rate.

V Rama Aravind,
Posted on: 2006-01-30

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