Open Economy Macroeconomics

Exchange Rate

Exchange rate quotations can be quoted in two ways – Direct quotation and Indirect quotation. Direct quotation is when the one unit of foreign currency is expressed in terms of domestic currency. Similarly, the indirect quotation is when one unit of domestic currency us expressed in terms of foreign currency. Let us learn in more detail about Exchange rate, Direct, and Indirect quotations.

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Direct and Indirect Quote

Let’s now look at it in detail. In financial terms, the exchange rate is the price at which one currency will be exchanged against another currency. The exchange rate can be quoted directly or indirectly.

The quote is direct when the price of one unit of foreign currency is expressed in terms of the domestic currency.

The quote is indirect when the price of one unit of domestic currency is expressed in terms of Foreign currency.

Since the US dollar (USD) is the most dominant currency, usually, the exchange rates are expressed against the US dollar. However, the exchange rates can also be quoted against other countries’ currencies, which is called as cross currency.

Now, a lower exchange rate in a direct quote implies that the domestic currency is appreciating in value. Whereas, a lower exchange rate in an indirect quote indicates that the domestic currency is depreciating in value as it is worth a smaller amount of foreign currency.

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Base and Counter Currency

Now that you understand the concept of the direct and indirect quote, let’s look at some other related concepts. The exchange rate has two components—the base currency and the counter currency.

In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency. In an indirect quotation, it’s the other way around. The domestic currency is the base and the foreign currency is the counter.

For example, USD to INR is a direct quote and INR to USD is an indirect quote. Most exchange rates list the USD as the base currency. Exceptions, in this case, include the Euro and the Commonwealth currencies such as Great Britain Pound (GBP), Australian Dollar (AUD), and the New Zealand Dollar (NZD).

Exchange Rate Types

Floating and Fixed Exchange Rate

Exchange rates do not remain constant. They can be floating or fixed. The exchange rate is considered to be floating when the currency rate is determined by market conditions. Most countries use a floating exchange rate. On the other hand, some countries prefer to fix their domestic currency as against a dominant currency, such as the USD.

Spot and Forward Exchange Rate

Exchange rates can also be classified into two types, namely spot, and forward exchange rates. The spot exchange rate is the current exchange rate at any given point in time. The forward exchange rate refers to the exchange rate that is stated and traded upon as of today but earmarked for payment and delivery at a future date.

Learn about National income identity for the open economy here.

Foreign Exchange Market

Exchange Rate

(Source: Wikipedia)

Know more about International Experience of Exchange Rate Systems

So, who determines the foreign exchange rate? The exchange rates are settled at the foreign exchange market, which is a decentralized market where currencies are bought, sold, and exchanged at current or fixed upon prices. The foreign exchange market is open 24 hours a day except for the weekends. The buying rate is the rate at which the money dealers will buy a currency and the selling rate refers to the rate at which they will sell a currency.

These quoted rates will usually accommodate the dealer’s profit margin. The foreign exchange rates don’t always remain the same. They are prone to fluctuation when the value of either of the two-component currencies in a currency pair changes. Currencies can become valuable or depreciate in value when the demand and supply factors change.

Solved Example for You

Q: Identify the indirect quote from the following options.

  1. CAD to USD
  2. USD to CAD

Ans: The correct answer is option ‘a’. The indirect quote is the Canadian dollar (CAD) to US Dollar (USD)

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One response to “Balance of Payments”

  1. Kristine says:

    What is the concept of balance payment?

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