1
TERMINOLOGIES
Foreign Exchange rate
• Foreign exchange rate is the rate at which one currency is
exchanged for other.
• It is the price of one currency in term of other
• The exchange rate between dollar and pound refers to
numbers of dollars required to purchased one pound
• For example if $2.50=£1
•
It means that value of £0.40 pound =$1
2
Foreign Exchange:
• The exchange rate of $2.50=£1 or
•
•
•
•
£0.40=$1 will be eliminated in world market by arbitrage
What is arbitrage:
it refers to the purchase of foreign currency in one
market where its price is low and sell it in another market
where it price is high
The effect of arbitrage is to remove differences in
exchange rate , so that single exchange rate prevail in
world market
If exchange rate is $2.48 in London exchange market and
$2.50 in new York exchange market
Foreign Exchange:
• Arbitrageurs will buy pounds in London and sell them in new
York for earning profit
• As a result the price of ponds in term of dollars in London
market rises and falls in the new York market
• This process will end the arbitrage practice
Determination of equilibrium
exchange rate
• The exchange rate in a free market is determined by the
demand and supply of foreign exchange
• Equilibrium exchange rate is a rate at which demand for
foreign exchange is equal to supply of foreign exchange
• It is the rate which clears the foreign exchange market
• Two method for clearing the market
• A) Demand and supply of dollars with price of dollars in
pounds
• B) Demand and supply of pounds with price of pounds in
dollars…………both method yields same result
Determination of equilibrium
exchange rate (cont…)
• 1) Demand for foreign exchange
• The demand for foreign exchange (pounds) is a derived from
demand from pounds
• It arises from import of British goods and services into U.S and
from capital movements from the U.S to Britain
• Demand for pounds implies supply of dollars
• When U.S businessmen buy British goods and services and
make capital transfers to Britain they create demand for
British pounds in exchange for U.S dollars
Determination of equilibrium
exchange rate (cont…)
• Demand curve for pounds DD is sloping downward
from left to right
• It means that lower the exchange rate on pounds(
pounds became cheaper) (dollars price of pound) the
larger will be demand for pounds in foreign market
• This means that British exports of goods and services
cheaper in term of dollars
• The opposite happens if exchange rate on pounds
(dollars price of pound) is higher
• It will make British goods and services dearer
Determination of equilibrium
exchange rate (cont…)
• Supply of foreign exchange
• Supply of foreign exchange in our case is the supply of pounds
• It arises from U.S exports of goods and services to Britain and
capital movement from U.S to Britain
• British holders of pounds wish to make payment in $, thus
supply of pounds in market will increase
• Supply curve for pounds SS is an upward sloping curve
• The relation between exchange rate on pounds (dollar price of
pounds) and supply of pounds is positive
• If exchange rate on pounds increases U.S goods and services
become cheaper in Britain ,they would purchase more and as
a result supply of pounds in a market increase
Determination of equilibrium
exchange rate (cont…)
Dollar price of pounds
S
R2
R
R1
S
0
D
Q
pounds
Determination of equilibrium
exchange rate (cont…)
• Given the demand and supply curve for foreign exchange, the
equilibrium exchange rate is determined where demand for
pounds intersects supply of pounds
• Equilibrium exchange rate is “R” and OQ shows equilibrium
demand and supply of foreign exchange rate
• If exchange rate is higher than equilibrium exchange rate it
means that supply of pounds is greater than demand for
pounds
• The price of pounds will fall and ultimately equilibrium
exchange rate will reach and economy will come back to
equilibrium point i.e point “E”
Determination of equilibrium
exchange rate (cont…)
• An exchange rate lower than equilibrium rate mean demand
for foreign exchange rate is greater than supply of foreign
exchange rate
• This leads to increase the price of pounds in foreign exchange
market
• so exchange rate will tends to increase and equilibrium rate
will re-established in market
•
Economy come back to equilibrium point i.e. point “E”
Theories of Foreign Exchange
1:The Mint Parity theory
2: The purchasing Power Parity Theory
3: The Balance of Payments theory
12
The Mint Parity Theory
This theory is associated with the working of the International Gold
Standard. (gold standard operated between 1880—1914 )
Under this system, the currency in use was made of gold or
convertible into gold at a fix rate. The value of one currency unit
was defined in terms of certain weight of gold, that is, how many
grains of gold is equal to one dollar or one pound etc.
The central bank of a country was ready to buy and sell gold at
specific price
The rate at which the standard currency of a country was convertible
into gold was called the Mint Price of gold.
13
Explanation of the Theory
The official British price of gold in British was £ 6 per once and
in the US price of gold $36 per once,
so they were the mint price of gold in respective countries.
The exchange rate between $ and £ would be fixed at $36/£6=
$6
This rate was called the mint parity or mint par of exchange
because it was based on the mint price of gold
Thus under the gold standard, the normal rate of exchange was
equal to the ratio of their mint par values R= $/ £
14
Explanation of Mint Parity Theory
(cont…)
• But the actual exchange rate could vary above and below the
mint parity due to cost of shipping the gold between
countries
• Suppose U.S has deficit in its BOP with Britain
• This deficit in BOP will be paid by U.S importer in term of gold
• Suppose the shipping cost of gold from U.S to U.K is 3 cents
• So U.S importer will have to pay $6.03 for one pound
• This is actual exchange rate
Assumption of the Mint parity Theory
1. It buys and sells gold in any amount at that price.
2. Supply of money consists of gold or paper currency which is
backed by gold.
3. There is movement of gold between countries
4. Capital is moveable within countries.
5. Price directly varies with money supply
16
Criticisms on Mint Parity Theory
1. The international gold standard does not exist now ever
since after 1930
2. The theory is based on the free buying and selling of gold
and its movement between countries , while Govt. do not
allow such sales or purchases and movement
3. The theory is fails to explain the determination of exchange
rates as most countries are on inconvertible paper
currencies
conclusion
The mint parity theory has been discarded since the gold
standard broke down now. There are neither free
movements of gold nor gold parities
17
The Purchasing Power Parity Theory (PPP)
The PPP theory was developed by Swedish economists
Gustav Cassel in 1920 to determine the exchange rate
between countries on inconvertible paper currencies.
This theory states that, the rate of exchange between two
countries is determined by purchasing power in two different
countries
PPP have two versions:
1. The absolute purchasing power parity theory
2. The relative purchasing power parity theory
18
PPP Theory
19
1) Absolute Purchasing power parity
The absolute version states that the
exchange rates between two countries
is equal to the ratio of the price level in
the two countries. The formula is,
R AB = PA /PB
where RAB is the exchange rate
between two countries A and B and PA
and PB refers to general price level in
two countries
20
Absolute Purchasing power parity
(cont..)
For example if price of one bushel of wheat is $1 in U.S and £1
in U.K then exchange rate between $ and £ is equal to 1
According to the law of one price, a given commodity should
have same price
So purchasing power of two currencies is at parity in both
countries
If the price of one bushel of wheat in term of $ were $0.50 in
U.S and £1.50 in U.K …firm would purchase wheat in U.S and
resell it in U.K at profit
Absolute Purchasing power parity
(cont..)
This commodity arbitrage would cause the price of
wheat to fall in U.K and rise in U.S until the prices
were equal to $1per bushel in both economies
Criticisms
This version is not use because it ignore the
transportation cost and other factors.
2) The Second Version ( Relative purchasing
parity)
According to this version the change in the exchange rate over
a specific period of time should be proportional to the relative
change in price level in the two nations over the same period
of time
The formula used for determination of exchange rate is
R1 =P1a/P0 . R0
P1b/P0
where R1 shows exchange rate in period 1, and R0 shows
exchange rate in base period
for example if general price level does not change in foreign
nation from the base period to period 1
Where as general price level in the home nation increase by 50%
23
The Second Version ( Relative purchasing
parity)
So according to PPP theory the exchange rate (price of a unit
of foreign currency in term of domestic currency) should be
50% higher in period 1 as compared to the base period (home
currency depreciated by 50%)
This theory can be explain with the help of other example.
Suppose India and England are on inconvertible paper
standard and by spending Rs.60, the bundle of goods can be
purchased in India as can be bought by spending £ 1 in
England. Thus, according to PPP, the rate of exchange will be
Rs. 60= £ 1
Suppose domestic price index increase by 300 and foreign
price index rises to 200 the new exchange rate will be Rs 60
=£1.5
Explanation (PPP)
The exchange rate would be a proper reflection of
the purchasing power in each country if the
relative values bought the same amount of goods
in each country.
25
BOP theory for Determination of
exchange rate
According to this theory ,exchange rate of a currency is
depends one on its BOP position
A favorable BOP raise the exchange rate
And unfavorable BOP reduces the exchange rate
Thus according to this theory exchange rate is determined by
the demand and supply of foreign exchange
Demand for foreign exchange arises from the debit side of the
balance sheet
Supply of foreign exchange arises from credit side of balance
sheet
BOP theory for Determination of
exchange rate (Cont…)
• When BOP is unfavorable it means that demand for foreign
currency is more than its supply
• It means that external value of domestic currency in relation
to foreign currency fall
• Consequently exchange rate to fall…..how ?
• Suppose RS 60=$1 , external value of domestic currency is
.017
• Due to unfavorable BOP Rs90=$1 so external value of
domestic currency is ……… .011
• On other hand if BOP is favorable it means that supply of
foreign is greater than demand
• It means that external value of domestic currency in relation
to foreign currency rise
BOP theory for Determination of
exchange rate (Cont…)
• Consequently exchange rate to rise
• Suppose RS 60=$1 , so external value of domestic currency is
.017
• Due to favorable BOP Rs 40=$1 so external value of domestic
currency is ……… .025
• In conclusion, in foreign exchange determination BOP is
important
•
BOP theory for Determination of
exchange rate (Cont…)
price of $ in Rupee
S
R2
R
R1
S
0
D
Q
Dollars