FOREIGN EXCHANGE MARKET

INTRODUCTION: The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is by far the largest financial market in the world, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The average daily trade in the global forex and related markets currently is over US$ 3 trillion.

Nature and Functions:

The foreign exchange market is the market in which foreign currencies are bought and sold. The buyers and sellers include individuals, firms, foreign exchange brokers, commercial banks and the central banks. Like any market, foreign exchange market is a system not a place. The system works through the facility provided by the key players of the market, viz., foreign exchange brokers, banks and the central banks, for sale and purchase of foreign currency. The major constituents of and dealers in foreign exchange in foreign exchange market are central banks, commercial banks, brokers, exporters and importers, investors, tourists, and immigrants. The relative place and importance of the exchange market players in the structure of the foreign exchange market is shown in the below figure. As the figure shows, central banks hold the top position in the foreign exchange market. They work as custodian of foreign exchange of the country and lender of the last resort. They have the power to control and regulate the domestic foreign exchange market to ensure that it works in an orderly manner. One of their main functions is to prevent by direct intervention, if necessary, the violent fluctuations in the exchange rate. The

main form of intervention is selling a foreign currency when it is overvalued and buying it back when it tends to be undervalued. Foreign exchange brokers hold the second most important place in the foreign exchange market. Brokers work as a link between the banks. They are the major source of market information. Their main function is to liaison the foreign exchange transactions between the actual buyers and banks, the sellers. They themselves do not buy or sell the foreign currency; they only strike the deal between the buyers and sellers, on commission basis. Commercial banks make the third important organ of the foreign exchange market. Banks dealing in foreign exchange play the role of market makers in the sense that they quote the daily exchange rates for buying and selling. They work also as the clearing house. They clear the market by buying the foreign currency in demand from the brokers and selling it to the buyers. At the bottom of the foreign exchange market are the actual buyers and sellers of the foreign currencies exporters, importers, tourists, investors and immigrants. They are the actual users of the foreign exchange. Those who need a foreign currency approach the commercial banks to buy the currency. Foreign exchange market is the biggest market in the world today, daily transaction exceeding 100$ billion. Most major countries have foreign exchange market centers. London, New York, Paris, Tokyo, Zurich, Frankfurt and Singapore are some prominent foreign exchange market centers for the US dollar. Unlike other markets, the foreign exchange market centers work 24 hours a day and seven days a week. The major functions of the foreign exchange market include: (i) Transferring foreign currency from one country to another where it is needed in the settlement of payments. (ii) Providing short-term credit to the importers, and, thereby, facilitating smooth flow of goods and services between the countries. (iii) Stabilizing the foreign exchange rate through spot and forward markets.

Kinds of Foreign Exchange Market

The foreign exchange market is classified on the basis of whether foreign exchange transactions are spot or forward. Accordingly, there are two kinds of foreign exchange markets: spot market and forward market. The nature of transactions in the spot and forward markets are described briefly.
(i)

Spot Market: The spot market refers to that segment of the foreign exchange market in which sale and purchase of foreign currency are settled within two days of the deal. The spot sale and purchase of foreign exchange make the spot market. The rate at which foreign currency is bought and sold in the spot market is called spot exchange rate. For all practical purposes, spot rate is treated as the current exchange rate. Forward Market: The forward exchange market refers to the deals for sale and purchase of a foreign currency at some future date at a presettled exchange rate. When buyers and sellers enter an agreement to buy and sell a foreign currency after 90 days of the deal, it is called forward transaction. The forward transactions in foreign exchange make the forward market. The exchange rate settled between the buyers and seller for forward sale and purchase of currency is called forward exchange rate.
(ii)

The Nature of Transactions in Foreign Exchange Market

The foreign exchange transactions involve risk and, therefore, profits. On the basis of their riskiness and profitability, foreign exchange transactions can be classified as (i) hedging, (ii) arbitrage, and (iii) speculation.
(i)

Hedging: Hedging is an important feature of the forward exchange market. When exporters and importers enter an agreement to sell and buy goods at some future date at current prices and exchange rate, it is called hedging. The purpose of hedging is to avoid losses that might be caused by exchange rate variations in future. The forward exchange market provides an opportunity to cover the risk arising out of exchange rate fluctuation and to avoid the resulting loss. Hedging, i.e., the forward foreign exchange transaction, takes place through the banks. The banks dealing in forward purchase and sale of foreign exchange provide the hedging facility to the exporters and importers. They provide the guarantee for payment to the exporters and supply foreign exchange to the importers at the agreed upon rate of exchange.

(ii)

Arbitrage: Arbitrage is an act of simultaneous purchase and sale of different foreign currencies in different exchange markets. The objective of arbitraging is to make profit by taking the advantage of different exchange rates in different exchange markets. The arbitraging serves as an equalizer and stabilizer of exchange rates in major exchange markets as it transfers currency from the market where it is low to the market where it is high. However, arbitrage works successfully only when foreign exchange market is free from controls or when controls, if any, are not of great significance.

(iii)

Speculation:

Speculative transactions in foreign exchange are opposite of hedging. In hedging, the buyers and sellers try to avoid risk, if any, due to fluctuation in the exchange rate, whereas speculation in foreign exchange is a deliberate assumption of risk to make profits from the fluctuations in the exchange rate. The speculative sale and purchase of foreign currency is based, as in all other speculative business, on the speculators expectations about the future exchange rates. The bears of the market expect the exchange rate between any two currencies to decline in the foreseeable future. On the other hand, bulls of the market expect the exchange rate to increase. Since bears expect foreign exchange to decrease in future, they sell their currency holding to avoid loss. The bulls, on the other hand, expect exchange rate to increase, and hence they buy the foreign currency with a view to selling it when exchange rate increases in future. Whether bulls and bears gain or loose depends on how correct they are in their expectations.

What are exchange rates?

The relatively small changes in the prices at which these trades occur are called exchange rates. Many travelers are familiar with the process of money changing from one currency to another when they cash in their foreign currency. The Foreign exchange market, however, involves these same transactions except on a grandiose scale. Foreign exchange rates, often calculated with a foreign exchange converter, can have immediate and profound effects on economic events even for the foreign traveler. International transactions between corporations can stall or halt when their countries currency rate

Where do exchange rates come from?

In the past, all world powers defined the price of gold in terms of their domestic currency. Countries could easily convert their currency to gold on demand, and varied the supply of money directly with the gain or loss of gold. The exchange rates between currencies remained fixed. Fixed exchange rates no longer exist, which is why there is a global market that deals solely in the exchange of currency. Many people profit off of fluctuation in different regions.

Determination of Exchange Rate in Free Exchange Market

The exchange rate is the price of a currency in terms of another currency. More precisely, exchange rate is the rate at which currency of a country is bought and sold against the currency of another country in the foreign exchange market. For example, Thomas Cook quoted the selling price of one unit of some foreign currencies in terms Indian rupee on the 17 th February 2000 as US$ = Rs 44.30; DM = Rs 22.45; F Fr = Rs 6.70; HK $ = Rs 5.75; Lire (100) = Rs 2.30; Yen (100) = Rs 40.75. These rates imply that foreign exchange dealers will sell these currencies at these quoted rates. Buying rates lower than the selling rates by the amount of dealers margin.

CHANGE IN THE EQUILIBRIUM EXCHANGE RATES The foreign exchange market conditions are not static. They are subject to change due to changing domestic and external economic conditions. Therefore, market determined exchange rate is subject to frequent variations due to the following factors. 1. Change in domestic prices: A change in domestic prices, foreign prices remaining constant, changes the demand and supply conditions of foreign exchange. For example, a rise in domestic prices in India, all other things remaining the same, reduces foreign demand for Indian goods and increases Indias demand for foreign foods. Consequently, Indias imports increase causing an increase in demand for foreign exchange and upward shift in the Indias demand curve. For the same reason, Indias exports decrease causing a leftward shift in her foreign exchange supply curve. Both these changes change the exchange rate. 2. Change in the real income: A change in real income of a country, other factors remaining the same, increases its demand for foreign goods and therefore demand for foreign exchange and the exchange rate. For example, if real income of India increases, ceteris paribus, her imports increase if they are income-elastic. Increase in imports increases Indias demand for foreign exchange. This makes the demand curve shift upward causing a rise in the exchange rate. Similarly, when real income of foreign countries increases, ceteris paribus, it results in appreciation of Indian currency. 3. Change in the rate of interest: Change in the interest rate in different countries affects the capital flows between the nations and demand and supply conditions. Capital tends to flow out from low-interest-rate countries to the high-interestcountries. The change in the pattern of capital flow leads to a change in demand and conditions for foreign exchange which changes the exchange rate. 4. Structural change: The structural change in an economy, for example, changes in the composition of GNP and technological and industrial innovations change this cost structure of a country which in its turn changes the relative price structure. Such changes cause a change in the demand and supply conditions and hence a change in the exchange rate. 5. Speculative demand and supply: The speculative demand for and supply of foreign exchange too change the position of the demand and supply curve3s and therefore the exchange rate. The factors noted above keep exchange rate floating. Such an exchange rate is called floating exchange rate. However, it is argued that if foreign exchange market is perfectly competitive, there will always be an order in the foreign exchange market and a stable

exchange rate. Whether exchange rate remains stable over a period of time depends on the demand and supply conditions.

Causes of changes in the exchange rate

The exchange rate between countries changes due to changes in demand or supply in the foreign exchange market. The factors which cause changes in demand and supply are discussed as under:
(1)

Changes in prices: it is change in the relative price levels that cause changes in the exchange rate. Suppose the price level in Britain rises relative to the US price level. This will lead to the rises in the price of British goods in terms of pound. British goods will become dearer in the US. This will lead to reduction in British exports to the US. So the supply of dollars to Britain will diminish. On the other hand, the American goods become cheaper in Britain and their imports into Britain increase. So the demand for dollars will increase. Thus the supply curve for dollars will shift to the left so that the exchange rate of is established at a higher level from the point of view of the US. It implies appreciation of the value of the dollar and depreciation of the value of the pound. Changes in Exports and Imports: the demand and supply of foreign exchange is also influenced by changes in exports and imports. If exports of the country are more than imports, the demand for its currency increases so that the rate of exchange moves in its favor. Conversely, if imports are more than exports, the demand for the

(2)

foreign currency increases and the rate of exchange will move against the country.
(3)

Capital Movements: Short-term or long-term capital movements also influence the exchange rate. Capital-flows tend to appreciate the value of the currency of the capital-importing country and depreciate the value of the currency of the capital-exporting country. The exchange rate will move in favor of the capital-importing country and against the capital-exporting country. The demand for the currency of the capital-importing country will rise and its demand curve will shift upward to the right and the exchange arte will be determined at a higher level, given the supply curve of foreign exchange.

(4)

Influence of Banks: banks also affect the exchange rate through their operations. They include the purchase and sale of bank drafts, letter of credit, arbitrage, dealing in bills of exchange, etc. These banking operations influence the demand for the demand and supply of foreign exchange. If the commercial banks issue a large number of drafts and letter of credit on foreign banks, the demand for foreign currency rises. The bank rate also influences the exchange. If the bank rate rises relative to other countries, more funds will flow into the country from abroad to earn high interest rate. It will tend to raise the demand for the domestic currency and the exchange rate will move in favor of the country. Converse will be the case when the bank rate falls. Influence of speculation: the growth of speculative activities also influences the exchange rate. Speculation causes short-run fluctuations in the exchange rate. Uncertainty in the international money market encourages speculation in foreign exchange. If the speculators expect a fall in the value of currency in the near future, they will sell that currency and start buying the other currency they expect to appreciate in value. Consequently, the supply of the former currency will increase and its exchange arte will fall. While the demand for the other currency will rise and its exchange arte will go up.

(5)

(6)

Stock Exchange Influences: Stock exchange operations in foreign securities, debentures, stocks and shares, etc. exert significant influence on the exchange rate. If the stock exchanges help in the sale of securities, debentures, shares, etc. to foreigners and the exchange rate also tends to rise. The opposite will be the case if the foreigners purchase securities, debentures, shares, etc. through the domestic stock exchanges. Structural Influences: structural changes are another important factor which influences the exchange rate of a country. Structural changes are those changes which bring changes in the consumer demand for commodities. They include technological changes, innovations, etc. which also affect the cost structure along with the demand for domestic products. It implies increase4 in exports, greater demand for domestic currency, appreciation of its value and rise in the exchange rate. Political Conditions: Political conditions in the country have a significant influence on the exchange rate. If there is political stability and the government is strong and efficient, foreigners will have tendency to invest their funds into the country. With the inflow of capital, the demand for domestic currency will rise and the exchange rate will move in favor of the country. On the contrary, if the government is weak, inefficient and dishonest and there is no safety to life and property, capital will flow out of the country and the exchange rate will move against the country.

(7)

(8)

How is the foreign exchange rate determined?

There is no simple answer to this question. It depends on whether foreign exchange market is free or controlled, and whether the government adopts fixed

or flexible exchange rate policy. The economists have attempted to explain the exchange are determination through different kinds of theories including the market theory, determination through different kinds of theories including the market theory, the purchasing power parity theory, monetary theory, and portfolio-balance theory. In this section, we will discuss only the first two theories which are:

THE MARKET THEORY OF EXCHANGE RATE

Market theory of exchange rate determination also called as demand and supply theory applies to the condition of the free market. A free foreign exchange market is the one in which there is no government intervention and no restriction on holding and transacting foreign currency. In a free foreign exchange market, the rate of foreign exchange is determined, like the price of a commodity by the demand for and supply of foreign exchange. The exchange rate determination in free foreign exchange market is illustrated in the figure.

The foreign exchange demand curves are shown by DD1 and DD2 and supply curve as shown by SS are the usual demand and supply curves. However, some explanations of demand and supply curves are in order. The demand for foreign exchange is a derived demand. It is derived from the demand for foreign goods, services and securities. The other components of demand for exchange come from speculators and monetary authorities wanting to build foreign exchange reserves. Thus, the demand for foreign exchange is a composite demand. The demand curve DD1 has an inverse relationship with the exchange rate. The reason is that a higher exchange rate implies higher prices of foreign goods and vice versa. Higher prices mean lower demand for foreign goods and lower imports. Lower import means lower demand

for foreign exchange. As the exchange rates goes down, foreign goods become cheaper and therefore imports increase. Increase in imports lead to a greater demand for foreign exchange. That is why foreign exchange demand curves show an inverse relationship between the exchange rate and demand for foreign exchange. Likewise, the supply curve of foreign exchange is derived from a composite supply of variety of goods, services and securities. It includes also the supply of foreign exchange by speculators, foreign exchange dealers, and the monetary authorities trying to get rid of their excess foreign exchange reserves. There is another way of looking at the supply curve of foreign exchange. The supply schedule of a countrys currency is, in fact, an inverted image of its demand for foreign exchange. For, when a country demands foreign currency, it offers its own currency in payment and, in the process, it supplies its own currency. The supply curve has a positive slope. Returning to the question of exchange rate determination, the foreign exchange demand curve DD1 and supply schedule SS intersect at point P determining the exchange rate at Rs.50 per dollar. At this exchange rate, the total demand for dollar equals the total supply of dollar at $10 million. It means that the dollar-rupee exchange market is cleared. Therefore, the exchange rate ($1=Rs 50) is the equilibrium exchange rate in the free foreign exchange market. In case demand for dollar increases for some reason, say, due to the increase in demand for the US goods, the demand curve will shift to DD2 and a new equilibrium exchange rate will be determined as $1=Rs 60 and market will be cleared at $12.5 million.

THE PURCHASING POWER PARITY THEORY

A Swedish Economist, Gustav Cassel developed the concept of equilibrium rate of exchange, popularly known as the purchasing power parity theory (PPP) after the First World War. This theory asserts that the relative value of different currencies corresponds to the relation between the real purchasing power of each currency in its own country. The purchasing power parity theory can be stated in the form of the following two statements: 1. Under inconvertible paper standard, the absolute rate of exchange between any two currencies is determined on the basis of their purchasing power in their respective countries.

2. The relative change in exchange rate between any two currencies is proportional to the change in the relative prices. The absolute rate of exchange is determined in terms of absolute prices. For example, suppose a basket of goods and services can be bought in India for Rs. 100 and in US for $2, both currencies being inconvertible paper currencies. Then the exchange rate between the two currencies will be determined as; $2= Rs 100 $1= Rs 50 The determination of the absolute rate of exchange is based on the assumption that there is no cost of transportation, no subsides. It is argued that since this assumption is unrealistic, the absolute version of the PPP is unrealistic. However, the absolute exchange rate can be worked out without this assumption. The statement (ii) of the PPP theory explains the change in the exchange rate over time with the change in purchasing power of the currencies. For example, suppose (i) P 0A and P0B are the price levels in countries A and B, respectively, in base year 0, (ii) R 0 is the exchange rate between the two currencies in year 0, and (iii) prices in the two countries change in year 1 to P1A and P1B , respectively. Then the exchange rate (R1) in year 1 between the two currencies can be worked out as follows: R1=R0*P1A/P0B P1B/P0B This formula serves a usual purpose of determining the exchange rate between any two currencies with changing prices.

CRITICISM OF THE PPP THEORY

The purchasing parity theory has been criticized on the following grounds. 1. The wholesale price index number(WPI) used in PPP theory does not give an accurate and relevant measure of purchasing power of a currency in the context of foreign trade. For determining the purchasing power of a currency, prices of only internationally traded goods are relevant, not WPI. Therefore, it does not give a realistic exchange rate. 2. Apart from goods, many service items, for instance, banking insurance and consultancy, etc. enter the international transactions. Besides, a large amount of

capital transfers take place between the nations. Such transactions do affect purchasing power of a currency. But, WPI does not take these transactions into account. 3. As Haberler has pointed out, tariffs, subsidy and embargo cause significant deviations in the purchasing power of a currency. But such items are not taken care of in the PPP theory. 4. The change in the exchange rate depends, by and large, on the elasticity of reciprocal demand for imports and exports. But PPP theory does not take this factor into account. 5. The PPP theory assumes that relative price is the sole determinant of the international transactions. This is not true. Changes in the exchange rate take place also due to disequilibrium caused by capital transfers, service payments and changes in the real income. In spite of these shortcomings, PPP theory can be used as the first approximation of an equilibrium rate of exchange for periods of serious and frequent price changes. For a more accurate measure of the exchange rate, other factors like capital transfers, changes in production technique and in real incomes need to be accounted for.

THE FIXED RATE AND

EXCHANGE ITS

DETERMINATION

Market determined exchange rate is called floating or flexible exchange rate. The flexible exchange rate system is certain disadvantages. The most serious disadvantage of flexible exchange rate is that it causes instability in trade, foreign investment, balance of payments and employment. A section of economists have, therefore, argued for fixed exchange rate system. The IMF has adopted a system of fixed exchange rate for its member nations with a provision of flexibility within a limited range. The fixed exchange rate is rule today rather than an exception. In this section, we will discuss briefly, the determination of the fixed exchange rates.

The fixed exchange rate

When the exchange rate between the domestic and foreign currencies is fixed by the monetary authority of the country and is not allowed to fluctuate beyond a limit, it is called fixed exchange rate. Under the IMF system, the monetary authority of a member nation fixes the official value of its currency in terms of a reserve currency (usually the US dollar) or a basket of key currencies. The exchange rate so determined is known as currencys par value. It is also called pegged exchange rate. However, flexibility is allowed with upper and lower limits prescribed by the IMF, usually 1% up and down, under normal conditions. The basic purpose of adopting fixed exchange rate system is to ensure stability in foreign trade and capital movements. Under fixed exchange rate system, the government assumes the responsibility of ensuring stability of exchange rate. To this end, the government undertakes to buy and sell the foreign currency-buy when it becomes weaker and sell when it gets stronger. Private sale and purchase of foreign currency is suspended. Any change in the official exchange rate is made by the monetary authority of the country in consultation with the IMF. In practice, however, most countries adopt a dual system: a fixed exchange rate for all official transactions and market rate for private transactions.

Determination of fixed exchange rate

The determination and regulation of the fixed exchange rate is illustrated in the figure. Suppose that Indias demand curve for foreign exchange (say, US dollar) is given by the demand curve D2 and dollar supply by the curve S. In the absence of the fixed exchange rate system, the exchange rate will be determined at R2 by intersection of foreign exchange demand curve (D2) and supply Scurve S. This exchange rate may fluctuate up and down to any level which is not desirable. Therefore, the Indian government adopts the fixed exchange rate system and fixes the exchange rate between R1 and R3 , that is, exchange rate variation is allowed between R1 and R3 . This implies that demand for dollar can fluctuate between lower and upper limits of OM and OQ, respectively, and exchange rate can move up and down between R1 and R3. So long as the demand variation is limited between OM and OQ and exchange rate between R1 and R3 , the monetary authority, need not intervene. But, if dollar demand an exchange rate variations cross these limits for such reasons as seasonal variations in demand, increase in imports, increase in short term foreign investment, and so on, then the authorities will be required to intervene to control the demand variation and limit the exchange rate variation within permissible limits, R1 and R3. For example, suppose demand for dollar increases and demand curve D2 shifts to D3 and dollar demand exceeds the upper limit by QR, then the authorities will sell QR dollars from its reserve to vent the demand pressure on exchange rate. Similarly, if for some reason, demand for dollar decreases and demand curve D2 shifts leftward to D1 then the authorities will buy dollars to the extent of MN to retain the exchange rate between R1 and R3. This is how the exchange rate in fixed exchange system works.

Why isnt our currency conversion fixed at a set rate?

Many groups have argued for global fixed exchange rates to introduce discipline in macroeconomic policies. If for example, there is a deficit in the balance of payments, the deficit country will experience an outflow of gold or reserves and a fall in the supply of money, which in turn will reduce expenditures, prices and nominal wages until the balance of payments is restored. The opposite would happen in the surplus country. The truth is that markets can change subtly all day, and a country can experience major financial problems through a variety of factors. Our world is fast-faced, just as our commerce. It simply isnt feasible to set a constant exchange rate in a world filled with so many variables. Foreign exchange currency converters, and Forex brokerage firms, can help others learn to manipulate their cash in a global marketplace. Currency trading is an exciting opportunity for investors and there is a wealth of information available to the new trader to get started. This website can help equip you when youre ready to begin your trading career.

Controversy on fixed versus flexible exchange rate

The IMF system of fixed exchange rate adopted under Bretten Woods Agreement in 1945 worked effectively until 1973. Thereafter, however, the IMF failed to provide adequate solution to three major problems: 1. Providing sufficient reserves to member nations to mitigate the short-run fluctuations in the BOP to maintain the fixed exchange rate system; 2. The problem of long term adjustment in BOP; and 3. Managing the crisis generated by speculative transactions. Consequently, the currencies of many countries, especially the reserve currencies, were devalued frequently in the early 1970s, causing instability in the exchange rate. This raised doubts about the sustainability of the Bretten Woods system and viability of the fixed exchange rate system and the Bretten Woods system broke down. The bread down of the system generated a debate on whether fixed exchange rate is desirable and whether it is sustainable. The arguments were put forward in favour of and against both fixed and flexible exchange rate systems. The argument in favour of one system is essentially the argument against the other. Therefore, we will study only the arguments in favour of each system.

The arguments in favor of Fixed Exchange Rates

1. The most powerful argument for fixed exchange rate is that it provides stability in the foreign exchange market; certainty about the future course of exchange rates; and it eliminates the risk caused by uncertainty. On the contrary, a flexible exchange rate causes uncertainty and often violent fluctuations in international trade and BOP disequilibrium. 2. Fixed exchange rate system creates conditions for smooth flow of foreign capital between nations as it ensures a given return on foreign investment. On the contrary, a flexible exchange rate system causes uncertainty about rate of returns and hence it constrains the international capital flows. 3. Fixed exchange rate eliminates the possibility of speculative transactions in foreign exchange, whereas flexible exchange rate encourages speculative transactions which by nature is destabilizing. 4. Fixed exchange rate system reduces the possibility of competitive exchange depreciation or devaluation of currencies. In case of need, assistance and guidance are provided by IMF. 5. A case of fixed exchange rate is also made on the basis of the existence of the currency union and areas. Flexible exchange rate is unsuitable for nations of the currency areas as it leads to a chaotic exchange rate and, hence, hampers trade between them.

ARGUMENTS FOR FLEXIBLE EXCHANGE RATE

1. Flexible exchange rate provides a good deal of autonomy in respect of domestic policies as it does not require any obligatory constrains. This advantage is of great significance in the formulation of domestic economic policies.

2. Flexible exchange rate is self adjusting and therefore it does not require the government to maintain an adequate foreign exchange reserves to stabilize the exchange rate.

3. Since flexible exchange rate is based on a theory, it has a great advantage of predictability and has the merit of automatic adjustment.

4. Flexible exchange rate as a barometer of actual purchasing power of a currency in the foreign exchange market.

5. Some economists argue that the most serious charge against the flexible exchange rate i.e. uncertainty is not tenable because speculative tendency under the system creates condition for certainty and stability. They argue that the degree of uncertainty under flexible exchange rate system, if any, is not greater than the one under the fixed exchange rate.

The debate on fixed versus flexible exchange rate system has remained inconclusive as it is seen that both the systems have their own merits and demerits. But both are important in their own place.