EXCHANGE RATE
DETERMINATION
Chapter 02
FOREIGN EXCHANGE
• Popularly referred to as "FOREX"
• The conversion of one country's currency into
that of another.
• It is the minimum number of units of one
countries currency required to purchase one
unit of the other countries currency.
WHY IT NEEDED???.....
• Different countries have different currencies with different
values….
Example: India - Rupees
America -Dollar
China - Yuan
• When trade takes place…..
the persons of these countries have to convert their
currencies to other countries currencies to make payments
• For this purpose the concept of foreign exchange come into
operation. Under mechanism of international payments, the
currency of a country is converted in to the currency of
another country through FOREIGN EXCHANGE MARKET.
FOREIGN EXCHANGE MARKET
• Also called “FOREX” market.
• It is the place were foreign moneys were bought and sold.
• It involves the buying of one currency and selling of another
currency simultaneously.
• Exchange rates are determined here….
• Has no geographical boundaries…..
FOREIGN EXCHANGE RATE
• It is the rate at which one currency will be exchanged for
another in foreign exchange.
• It is also regarded as the value of one country’s currency in
terms of another currency.
There are three basic types;
1. Fixed rate
2. Floating rate
3. Managed rate
1. FIXED EXCHANGE RATE
• It is the system of following a fixed rate for converting
currencies.
• In this system, the government (or the central bank acting on
its behalf) intervenes in the currency market in order to keep
the exchange rate close to a fixed target.
•
It does not allow major fluctuations from the central rate.
Advantages
 It provide the stability of exchange rate.
 Fixed rates provide greater certainty for exporters and
importers.
Disadvantages
 Too rigid to take care of major upheavals.
 Need large reserves to defend the fixed
exchange rate.
 May cause destabilizing speculations; most currency crisis
took place under a fixed exchange system.
2. FLOATING/FLEXIBLE EXCHANGE RATE
• Under the flexible exchange rate system, the rate of exchange
is allowed to vary to suit the economic policies of the
government.
• Flexible exchange rates are exchange rates, which fluctuate
according to market forces.
• The value of the currency is determined solely by the forces
of demand and supply in the exchange market.(self correcting
mechanism)
Advantages
 Automatic adjustment for countries with a large balance of
payments deficit.
 Flexibility in determining interest rates
 Allow countries to maintain independent economic policies.
 Permit a smooth adjustment to external shocks.
 Don't need to maintain large international reserves.
Disadvantages:
 Flexible exchange rates are highly unstable so that flows of foreign
trade and investment may be discouraged.
 They are inherently inflationary.
3. MANAGED EXCHANGE RATE
• Managed exchange rate systems permit the government to
place some influence on an exchange rate that would
otherwise be freely floating.
• Managed means the exchange rate system has attributes of
both systems. Through such official interventions it is possible
to manage both fixed and floating exchange rates.
Simple Mechanism of Demand &
Supply
• As stated earlier exchange rate is determined by its the
forces of supply and demand.
• Therefore, if for some reason people increase their
demand for a specific currency, then the price will rise
provided that the supply remains stable.
• On the contrary, if the supply is increased the price will
decline and it is provided that the demand remains
stable.
Purchasing Power Parity Theory (PPP Theory)
•
Most widely accepted theory
“According to PPP theory, when exchange rates are of a
fluctuating nature, the rate of exchange between two
currencies in the long run will be fixed by their respective
purchasing powers in their own nations.”
•
i.e the price of a good that is charged in one country
should be equal to the one charged for the same good in
another country, being exchanged at the current rate.
The Balance of Payments
(BOP) Approach
• The relationship between the BOP and exchange rates can be
illustrated by the use of a simplified equation that summarizes
BOP data:
Current
Account
Balance
Capital
Account
Balance
Financial Reserve
Account Balance
Balance
(X – M) + (CI – CO) + (FI – FO) + FXB =
Balance
of
Payments
BOP
Where X = exports of goods and services, M = imports of
goods and services, CI = capital inflows, CO = capital outflows,
FI = financial inflows, FO = financial outflows and FXB = official
monetary reserves.
The Balance of Payments
(BOP) Approach
• Fixed Exchange Rate Countries:
– Under a fixed exchange rate system, the government bears
the responsibility to ensure a BOP near zero.
– To ensure a fixed exchange rate, the government must
intervene in the foreign exchange market and buy or sell
domestic currencies (or sell gold) to bring the BOP back to
near zero.
– It is very important for a government to maintain
significant foreign exchange reserve balances to allow it to
intervene in the foreign exchange market effectively.
The Balance of Payment Approach
• The balance of payments approach is another method
that explains what the factors are that determine the
supply and demand curves of a country’s currency.
• As it is known from macroeconomics, the balance of
payments is a method of recording all the international
monetary transactions of a country during a specific
period of time.
• The transactions recorded are divided into four
categories: the current account transactions, the
capital account transactions, financial account and the
central bank transaction.
CURRENT ACCOUNT
export and import of goods &services
CAPITAL ACCOUNT
Capital transfers
FINANCIAL TRANSFERS
Foreign direct investment
Portfolio investment
RESERVEBANK TRANSACTIONS
• According to the theory, a deficit in the balance of
payments leads to fall or depreciation in the rate of
exchange, while a surplus in the balance of payments
strengthens the foreign exchange reserves, causing an
appreciation in the price of home currency in terms of
foreign currency. A deficit balance of payments of a
country implies that demand for foreign exchange is
exceeding its supply.
• As a result, the price of foreign money in terms of
domestic currency must rise, i.e., the exchange rate of
domestic currency must fall. On the other hand, a
surplus in the balance of payments of the country
implies a greater demand for home currency in a
foreign country than the available supply. As a result,
the price of home currency in terms of foreign money
rises, i.e., the rate of exchange improves.
DETERMINANTS OF FOREIGN
EXCHANGE RATE
1. Interest Rate
Whenever there is an increase interest rates in domestic
market there will be increase investment funds causing a
decrease in demand for foreign currency and an increase in
supply of foreign currency.
2. Inflation Rate
when inflation increases there will be less demand for
local goods (decreased supply of foreign currency) and more
demand for foreign goods (increased demand for foreign
currency).
3. Government budget deficit or surplus
The market usually react negatively to widening govt. budget
deficits and positively to narrowing budget deficits. This will
result in change in the value of countries currency.
4. Political conditions
Internal, regional and international political conditions and
events can have a profound effect on currency market