The foreign exchange rate is the price of one currency in terms of another currency, A fall in the foreign exchange rate implies that the price of foreign currency. in terms of domestic currency. has decreased. Since foreign goods and services have become cheaper. the domestic country can now: buy higher quantity. This increases the demand for foreign currency in the domestic country.For instance. suppose the foreign exchange rate between India and UKhas decreased. The price of one pound has fallen from 70 to 60. lt implies that Indians have to pay only 60 to buy one pound worth of goods compared to 70 prior to falling exchange rate.Since goods in UKhave become cheaper for India, Indians will buy more of them. This increases the demand for UKpounds in India.Thus a fall in foreign exchange rate causes a rise in its demand.

Appreciation of a currency means an increase in the value of the domestic currency in terms of the foreign currency. The price of the domestic currency, in terms of a foreign currency, increases, and the foreign exchange rate decreases. For instance, suppose rupee has appreciated in terms of a pound. That is, the foreign exchange rate between India and UK has decreased. The price of one pound 11 has decreased from Rs.70 to Rs.60. It implies that Indian citizens can buy one pound worth of goods 11 by parting only Rs.60 compared to Rs.70 prior to fall in the exchange rate. Since UK goods have become cheaper for Indians, they will buy more of them. Consequently, Indian imports from the UK will increase.
 

The balance of trade is the difference between the value of exports (X) and the value of imports(M). That is,
Balance of Trade = Value of Exports - Value of Imports
Given: Balance of Trade = (-) Rs.5,000 crores
Value of Imports = Rs.9,000 crores
Thus, 5000 = Value of Exports - 9000
Value of Exports = - 5000 + 9000 = 4000
The value of exports is Rs.4,000 crores.

Sources of Demand for Foreign Exchange
(i) Purchase of goods and services from other countries
(ii) Send gift abroad
(iii) Purchase of financial assets in a particular country
(iv) Speculative trading on the value of the foreign currencies'
Sources of Supply of Foreign Exchange
(i) Foreigners purchasing home country's goods and services through exports
(ii) Foreign investment in home country through joint ventures
(iii) Foreign investment in home country through the financial market operations
(iv) Foreign currencies flow into the economy through the currency dealers an speculators

Following are the causes of disequilibrium in Balance of Payments:
1. Natural Causes
Natural calamities like famine, flood, etc. may cause disequilibrium in the Balance of Payments of an economy as these calamities result in a reduction in production and exports and increase in imports.
2. Economic Causes
(i) Economic Development: In order to accelerate the pace of development, underdeveloped countries have to depend on foreign assistance.These countries import advanced machinery, capital goods, and raw material, etc, which results in the excess of imports over exports.Hence, there arises the problem of disequilibrium in Balance of Payments.
(ii) Cyclical Fluctuations: Cyclical fluctuations like inflation and depression also cause the problem of disequilibrium of Balance of Payments. If there is a depression in the world market than exports of a country are affected adversely. Similarly, if prices start rising within the economy, the rate of increase in imports exceeds that of exports, which results in disequilibrium.
(iii) Capital Outflow: If a country invests its capital in other countries in order to earn more dividend then it may result in unfavorable Balance of Payments of the country investing the capital and favorable Balance of Payments of the country where the capital is invested.Hence, the problem of disequilibrium arises.
3. Political Factors
Government expenditure in foreign countries, political instability, cause disequilibrium political relations with other countries partition or unification of cause disequilibrium in Balanceof Paymentsof a country.

The balance of Payments (BoP) records the transactions in goods, services, and assets of the residents of a country with the rest of the world. It also records the country's demand for and supply of foreign exchange.
Items of Current Account
(i) Export and Import of Goods: Current account shows exports and imports of visible items i.e., goods like machinery, wheat. steel, etc.
(ii) Export and Import of Services: Current account shows exports and imports of invisible items i.e., services like banking, tourism, insurance, etc.
(iii) Unilateral Transfers: These are those receipts, which residents of a country receive or payments that the residents of a country make without getting anything in return. Receipts from abroad are entered as positive items and payments abroad are entered as negative items.
(iv) Private Transfers: These are gifts that domestic residents receive from or make to foreign residents.
Items of Capital Account
(i) Private Transactions: These are transactions that affect the assets or liabilities of individuals, business, etc. and other non-government entities.
(ii) Official Transactions: These are the transactions that affect the assets and liabilities by the government and its agencies.
(iii) Direct Investment: Direct investment means the act of purchasing an asset and at the same time acquiring control of it.
(iv) Portfolio Investment It is the acquisition of an asset that does not give the purchase control over the asset.

Foreign exchange rate is the price of one unit of the foreign currency in terms of the domestic currency.
Determination of Foreign Exchange Rate: Foreign Exchange Rate is determined in the exchange market at the point of intersection of foreign exchange demand and supply curves.
I. Demand Curve of Foreign Exchange: A country is dependent on other countries for its requirements of imports and foreign capital. Demand for foreign exchange arises to make payments for these imports. There is an inverse relationship between the demand 'for foreign exchange and the rate of exchange. If the exchange rate increases, the demand for foreign exchange would fall and the vice-versa. In the diagram, demand for foreign exchange is 00 when the exchange rate is OR. When the rate of exchange falls to ORI then demand foreign exchange increases to doI' Demand curve for foreign exchange (DO) curve slopes downwards from left to right.

2. Supply Curve of Foreign Exchange: Supply of foreign exchange depends on a number of factors like the value of exports of a country, import of capital, the extent of foreign investment, etc. There is a direct relation between exchange rate and the supply of foreign exchange. An increase in the exchange rate results in an increase in the supply of foreign exchange and vice-versa.

In the diagram, the supply of foreign exchange is OS when the exchange rate is equal to OR. If the exchange rate is increased to ORI, the supply of capital also increases to OS I' SS is the positively sloped supply curve of foreign exchange.
3. Equilibrium Foreign Exchange Rate: Equilibrium exchange rate is determined at a level where demand for foreign exchange is equal to the supply of foreign exchange. The determination of equilibrium foreign exchange rate can be explained with the help of given diagram:

The demand for foreign exchange is equal to the supply of foreign exchange at point E.the equilibrium foreign exchange rate is OR and equilibrium quantity of foreign exchange is OQ. MN represents excess demand for foreign exchange at ORI. Similarly, KL represents excess supply of foreign exchange at OR2

Arguments in Favour of Fixed Exchange Rate
1. Encouragement to Foreign Trade: The system of fixed exchange rate provides a suitable environment for foreign trade. The exporters and the importers have no fear of changes in the prices of goods and it helps to promote the foreign trade.
2. End to Speculations: There is no uncertainty in the foreign exchange market under the system of fixed exchange rate. It helps to bring an end to the activities of speculation as a result of uncertainty.
3. Internal Stability: Fixed exchange rate results in internal economic stability of a country. The fluctuations in the price level are reduced to the minimum on account of stability of exchange rate and the prices of imports and exports.
4. Useful for Small Countries: For the small countries like Denmark, Belgium, etc. this system of the exchange rate has turned out to be very useful. For the countries dependent on foreign trade for their economic development, the stability of exchange rate is essential. Flexibility in the rate of exchange may adversely affect the process of economic development of these countries. 

Arguments against Fixed Rate of Exchange
1. Monetary Dependence: If the exchange rate is fixed then the unfavorable Balance of Payments of a country has an adverse effect on the level of domestic output and income. Under such a situation, the government of a country will have to adopt such a monetary policy, which does not influence its exchange rate. Thus, the government is not free to formulate an independent monetary policy.
2. Cost-price Relationship: The fixed exchange rate is not determined in accordance with the value theory of price determination. Since economic policies of different countries are not alike, their cost-price relationships do not remain stable. Thus, fixed exchange rate does not enable us to analyze the changes in cost-price relations and their effect on the exchange rate.
3. Increase in Demand for Foreign Exchange: The demand for foreign exchange in a country increases under the system of fixed exchange rate. Therefore, the government will have to accumulate the stock on a foreign exchange and consequently, will have to bear the opportunity cost of foreign exchange.
4. Slow Rate of Growth: There is a lack of co-ordination among the economic policies of different countries under the system of fixed exchange rate. As a result, a country fails to achieve the desired rate of growth in the absence of co-ordination and co-operation of other countries.

Arguments in Favour of Flexible Exchange Rate
1. Solves the Problem of BoP Deficit: The flexible exchange rate helps to solve the problem of BoP deficit of a country. For example, if demand for foreign exchange exceeds its supply, the rate of exchange will increase to attain equilibrium. On the other hand, if the supply of foreign exchange exceeds its demand, the rate of exchange will decrease to attain equilibrium.
2. Effective Monetary Policy: According to Prof. Friedman, the monetary policy of a country can be effectively implemented if its exchange rate is flexible. lf the objective of monetary policy is to increase the level of production then rate of interest will be reduced to provide an incentive for investment. It will also result in an increase in the level of output and' hence the exports.
3. Regulations of Import and Export: The level of production, income, and employment keep on changing in an economy. These changes influence the demand for and supply of goods. Keeping in view the demand and supply of goods, the government of a country may introduce changes in its imports and exports, which are possible only under the system of the flexible exchange rate.

Arguments against Flexible Exchange Rate
1. Effect on Economic Structure: The economic activities of the intemational market have a direct impact on the structure of an economy if the exchange rate is flexible. The fluctuations in international market influence the price level, level of output and employment of an economy.
2. Uncertainty: Flexible exchange rate creates an environment of uncertainty in the international market, which in tum adversely affects the flow of capital among the countries. Moreover, it hinders the process of borrowing and lending of loans in the international market.
3. Internal Instability: The system of the flexible exchange rate, sometimes, results in the problem of internal instability in a country if the assumptions of full employment, perfect competition and perfect mobility of factors of production are not fulfilled.
4. Unnecessary Capital Movements: Under the system of the flexible exchange rate, capital movements among the countries may increase unnecessarily. Such capital movements may prove to be harmful to the structure of an economy.