In this case, Exchange Rate of a currency is fixed by the Government
Exchange Rate does not fluctuate daily
(Example- Suppose Govt fix exchange Rate at Rs 70 per $,it will remain the same unless govt changes it
This is done to ensure stability in foreign trade
Govt may Increase the exchange Rate to 80/$ called Devaluation) or Decrease Exchange Rate to Rs 60 per $ Called Revaluation
When is Devaluation Done
If Govt Wants to increase Exports
It will fix Higher Exchange Rate
Example - It will change Exchange Rate of Dollar from Rs 70 per $ to Rs 80 per $
Hence, it will make domestic currency cheaper as compared to foreign currency and in turn domestic goods cheaper
There will be excess supply of foreign currency in the market
To prevent this, Govt will Purchase Foreign Currency
When is Revaluation done
In this case, Govt fixes Lower Exchange Rate
Example - It will change Exchange Rate of Dollar from Rs70 per $ to Rs 60 per $
Hence, it will increase value of domestic currency cheaper as compared to foreign currency
For doing this, Govt will Sell Foreign Currency
| Basis | Devaluation | Revaluation |
| Meaning | It means Reduction in Price of Domestic Currency in terms of all foreign currency | It means Increase in Price of Domestic Currency in terms of all foreign currency |
| In this case, Higher Exchange Rate is fixed by Govt | In this case, Lower Exchange Rate is fixed by the govt | |
| Example | Exchange Rate increased from Rs 70 per $ to Rs80 per $ | Exchange Rate decreased from Rs 70 per $ to Rs60 per $ |
| Hence, Value of Rupee decreases as compared to dollar | Hence, Value of Rupee increases as compared to dollar | |
| Method | When the govt increases exchange rate | When the govt decreases exchange rate |
| There is excess supply of foreign currency in market | There is excess demand of foreign currency in market | |
| So Govt buys foreign Exchange from the market | Govt Sells foreign Exchange in the Market |
Summary
In fixed exchange Method
Govt keeps exchange rate fixed
Exchange Rate does not fluctuate daily
This is done to ensure stability in foreign trade
Govt may Increase Exchange Rate(Called Devaluation)
or
Govt may decrease Exchange Rate (Called Revaluation)
Difference between Fixed Exchange Rate and Flexible Exchange Rate
| Fixed Exchange Rate | Flexible Exchange Rate |
| In this case, Exchange Rate it Fixed by Government | In this case, Exchange Rate is determined by forces of demand and supply |
| Exchange Rate Remains fixed and does not fluctuate | Exchange Rate Fluctuates Daily |
| There may be Devaluation or Revaluation of Currency by the Govt | There may be Depreciation or Appreciation of Currency due to change in demand and supply of foreign currency |
| There is more stability of foreign trade | It is less stable as exchange rate keeps on changing |
| There is more role of Govt and Central Bank as it has to buy and sell foreign currency | There is less role of govt as exchange rate is automatically determined |
| This method is rarely used | This method is normally used by all developed countries |
What is Pegging and Parity Value in Fixed Exchange Rate System?
In Pegging
Exchange Rate of a currency is tied to some other currency or group of currency
Example
Saudi Arabia has pegged its currency Riyal to Dollar since 2003
Peg Rate is 3.75
It means
1 Riyal = 3.75 Dollar
In Parity Value
Exchange Rate of a currency is fixed to an equal value of some commodity
Example
Price of gold in terms of rupee fixed at Rs 4800 /gram
Price of gold in terms of dolar fixed at $ 60/gram
Hence, Equivalent Price of USA Dollar against rupee= 4800/60 = Rs 80/Dollar
NCERT Questions
Question 7
Differentiate between devaluation and depreciation
View answer
| Basis | Devaluation | Depreciation |
| Meaning | It means Reduction in Price of Domestic Currency in terms of all foreign currency | It means Increase in price of Foreign Currency as compared to indian Currency |
| Reason | It is fixed by the government | It is caused by Increase in Demand of Foreign Exchange or Decrease in Supply of Foreign Exchange |
| Example | Exchange Rate increased from Rs 70 per $ to Rs80 per $ | Suppose Exchange Rate is Rs 70. After 1 year,it Increases to Rs 75 |
| Hence,Value of Rupee decreases as compared to dollar. | It means Value of Dollar has increased as compared to Indian Rupee. We can also say that,Value of Indian Rupees has depreciated (decreased) as compared to US Dollar | |
| System | It exists under Fixed Exchange rate system | It exists under Flexible Exchange rate system |
Question 16
If inflation is higher in country A than in Country B, and the exchange rate between the two countries is fixed,
what is likely to happen to the trade balance between the two countries?
View answer
If inflation in country A is higher than Country B and the exchange rate is fixed.
It would be beneficial for country B to export goods to Country A.
Similarly, it would be beneficial for country A to import from country B.
Country B would not import goods from Country A because the rate of inflation there is higher so it would be expensive for country B
So, country A will have a trade deficit as it will have more imports than exports
Country B will have a trade surplus as it will have more exports than imports
Other Books
Question 1
In the following questions, select the correct answers:
Devaluation of currency means:
- Reduction in the value of domestic currency by the market forces
- Reduction in the value of domestic currency by the government
- Both A and B
- Neither A nor B
View answer
B. Reduction in the value of domestic currency by the government
Explanation
Devaluation means Reduction in Price of Domestic Currency in terms of all foreign currency
It is done by the government
Question 2
When the government wants to strengthen the rupee, it ___ foreign currency and ___ domestic currency.
- sells, buys
- sells, sells
- buys, sells
- buys, buys
View answer
A. sells, buys
Explanation
By selling foreign currency and buying domestic currency, government 1st increases the supply of foreign currency
This leads to fall in price of foreign currency
Then, by buying domestic currency, government increases its demand which increases price of domestic currency.
Question 3
The Gold Standard system includes:
- Fixing values of foreign currencies IN terms of US Dollar
- Fixing values of foreign currencies in terms of gold
- Both A and B
- None of these
View answer
B. Fixing values of foreign currencies in terms of gold
Explanation
Under Gold Standard System, values of all currencies were fixed in terms of gold
and then these currencies could be compared against each other
Example
1 Pound = 4 gm of gold
Rs 1 = 2 gm of gold
then
1 Pound = Rs 2
Oswaal Questions
Question 1
Which of the following statements is not true?
- Depreciation of the foreign currency leads to the fall in exports.
- Devaluation of the domestic currency leads to a rise in imports.
- Appreciation of domestic currency leads to rise in exports.
- Appreciation of foreign currency leads to fall in imports.
View answer
A. Depreciation of the foreign currency leads to the fall in exports.
Explanation
Depreciation of home currency implies fall in the price of domestic goods for the foreign buyers.
Question 2
Identify the correct pair as given in Column B by matching them with respective concepts in Column A:
| Column A | Column B |
| (1) Reduction in the value of domestic currency by the government | (a) Devaluation |
| (2) Reduction in the value of domestic currency through market forces | (b) Appreciation |
| (3) Increase in the value of domestic currency by the government | (c) Depreciation |
| (4) Increase in the value of domestic currency through market forces | (d) Revaluation |
- 1 - (a)
- 2 - (b)
- 3 - (c)
- 4 - (d)
View answer
A 1 - (a)
Explanation
Devaluation refers to fall in the value of domestic currency due to deliberate increase in foreign exchange rate by the government which follows fixed exchange rate system.
Question 3
Assertion (A): When in order to buy 1 US dollar Rs 80 are needed instead of Rs 75, domestic currency shows depreciation.
Reason (R): Depreciation of domestic currency refers to fall in the value of domestic currency in terms of foreign currency caused by rise in foreign exchange rate in the foreign exchange market.
Mark the correct choice:
- Both Assertion (A) and Reason (R) are true, and Reason (R) is the correct explanation of the Assertion (A).
- Both Assertion (A) and Reason (R) are true, but Reason (R) is not the correct explanation of the Assertion (A).
- Assertion (A) is true, but Reason (R) is false.
- Assertion (A) is false, but Reason (R) is true.
View answer
A Both Assertion (A) and Reason (R) are true, and Reason (R) is the correct explanation of the Assertion (A).
Explanation
Here, domestic currency shows depreciation because more rupees are to be paid to buy one US dollar.