Determination of Exchange rateSYBcom Sem IVSDJ International CollegeAsst. Prof. Vaghela Nayan

What is Foreign Exchange?• Foreign Exchange refers to the mechanism of the

ways and means by which payment in connection with International Trade are effected.• In the words of S.E. Thomas, “Foreign exchange is

that branch of the science of economics in which we seek to determine the principles on which the people of the world settle their debts one to another.”• According to Heartley Withers, “Foreign exchange

are a mechanism by which international indebteness is settled between one country and another.”

Meaning of Rate of Exchange

• The rate of exchange is the price of one currency expressed in terms of another currency, it is the reflection of the external value of the domestic currency.• It should also be noted here that exchange rate is

not always constant, it goes on changing from time to time o account of change in demand for and supply of foreign currency.

Determination of exchange Rate

• There are three important theories for the determination of exchange rate under different monetary standards.

A. Mint Par Theory: When the two countries are on Gold Standards, the rate of exchange is determined according to Mint Par Theory.

B. Balance of Payment Theory: This is also known as Demand and Supply Theory according to which the rate of exchange is determined by the demand for and supply of foreign currency, that is to say, the exchange rate depends on the balance of payment situation of a country. Favourable BOP reflects strong exchange rate and vice-versa.

C. Purchasing Power Parity Theory: When the two countries are on inconvertible paper currency standard, the rate of exchange is determined according to purchasing power parity theory.

• The basic idea underlying the PPP theory is that every unit of currency possesses a certain degree of purchasing power, and therefore when the domestic currency of a country is exchanged against the foreign currency, what happen in fact is that the domestic purchasing power is exchanged for foreign purchasing power. So the rate of exchange is getting affected by the relative purchasing power of the currencies of different countries.

• Statement of the Theory: “In the case of countries on inconvertible paper currency standard, the basic rate of exchange between them is determined by purchasing power – the ratio of purchasing power of two currencies in their respective home markets. The actual rate of exchange at any time may move away from the purchasing power parity due to influences of demand and supply for foreign currency, but the purchasing power par is the point towards which the rate will constantly tend to move and at which it must ultimately comes to rest.”

Two Versions of the Theory1. Absolute version:• This concept posits that the exchange rate between two

countries will be identical to the ratio of the price levels for those two countries. This concept is derived from a basic idea known as the law of one price, which states that the real price of a good must be the same across all countries. To illustrate why this makes sense, suppose that soybeans are currently priced at $5 a bushel in the U.S., that soybeans are priced at 550 per bushel in India, and that the exchange rate is 50 Rs. per dollar. Suppose that the price of soybeans goes up to 605 per bushel (a 10% increase) in India, while the price of soybeans in the U.S. only goes up on 5%, to $5.25 a bushel. If there is no depreciation in the INR. to offset the 5% difference, then Indian soybeans will not be competitive on the international market and trade flowing from the U.S. to India will greatly increase.

• If we take weighted averages of prices for all goods within an economy, absolute purchase power parity maintains that the currency exchange rate between two countries should be identical to the ratio of the two countries' price levels.• This relationship can be expressed as:• Formula• S = P ÷ Pf

• Where S is the spot exchange rate between two countries (the rate of the amount of foreign currency needed to trade for the domestic currency), P is the price index for a domestic country and Pf is the price index for a foreign country. Note that the exchange rate used here is an indirect quote.

• The following conditions must be met for this relationship to be true:

1. The goods of each country must be freely tradable on the international market.

2. The price index for each of the two countries must be comprised of the same basket of goods.

3. All of the prices need to be indexed to the same year.• Even if the law of one price holds for each individual

good across countries, differences in weighting will cause absolute purchasing power parity. Determining comparable average national price levels is actually quite difficult and is rarely attempted. Analysts usually examine changes in price levels (indexes), which are easier to calculate; this gets around some of the problems of comparability.

2. Relative version:• Under absolute version of the theory, the purchasing power

of two countries is explained with reference to only one commodity, where as under relative version, the internal purchasing power of the two countries is considered with reference to number of goods and services. Thus, the theory in its relative version states that the changes in the rate of exchange are governed by changes in the ratio of the respective purchasing power of the two countries.

• Here, some past exchange rate is adopted at the base rate and changes therein are measured by the ratio of price indices of respective countries. In other words, according to the relative version of the theory, when the price level in both the countries changes, the new exchange rate will be the old base rate multiplied by the quotient between the degrees of change in the purchasing power of two countries.

• Symbolically it can be expressed as:Rt = R0 x x

Here, Rt = New exchange rateR0 = Base ratePa0 = Price index of home country in base

periodPa1 = Price index of home country in current

periodPb0 = Price index of home country in base

periodPb1 = Price index of home country in current

period

Criticisms of the Purchasing Power Parity Theory1. It ignores many real determinants: The theory shows a direct link

between the purchasing power and exchange rate and ignores many other factors of exports and imports involved behind the operation.

2. It is based on unrealistic assumptions: According to Heckscher, “the conception that the exchanges represent relative price levels; or what is the same thing, that the monetary unit of a country has the same purchasing power both within the country and outside, it is correct only upon the never existing assumption that all goods and services can be transferred from one country to another without cost.

3. The PPP theory is an empty truism: It states that changes in foreign exchange rate must reflect changes in price levels of the countries. But, goods traded internally only have no direct bearing on the exchange value of the currency and their prices may be fluctuating without affecting the exchange rate. “Confined to internationally traded commodities, the purchasing power parity theory becomes an empty truism,” says Keynes.

4. The theory overlooks the influence of demand and supply factors in foreign exchange: Nurkse underlines that the theory considers “demand simply as a function of price, leaving out of account the wide shifts in the aggregate income and expenditure which occur in the business cycle and which lead to wide fluctuations in the volume and hence the value of foreign trade even if prices or price relationships remain the same.”

5. The theory holds good in the long run: But, what about the short term which really is more significant? Because, “in the long run we are all dead, and after death, there is no economic problem.”

6. According to the theory, to calculate the new equilibrium rate, one must know the base rate, i.e. the old equilibrium rate: But it is difficult to ascertain the particular rate which actually prevailed among the currencies as the equilibrium rate. Moreover, the calculated new rate would represent the equilibrium rate at purchasing power parity only if economic conditions have remained unchanged.

7. It disregards the basis of international trade: The theory assumes that we are dealing with a similar group of commodities in both countries. This assumption is not tenable, when the very base of international trade is geographical specialization in production. Moreover, the concept of a change in the price is vague in theory. Prices of all commodities never move uniformly. Prices of some commodities rise or fall much more than those of others. Under such conditions, no simple comparison can be made between the price movements in different countries.

8. The theory involves a practical difficulty of measuring the true purchasing power of a currency:The theory suggests the use of price indices for measuring the changes in purchasing power. But there are several kinds of price indices such as wholesale price index numbers, cost of living index numbers, etc. So the question arises: which of these index numbers should be used for calculating the changes in the purchasing power?

9. The theory neglects capital transactions in international economic relations: It fails to take into consideration any item in the balance of payments other than merchandise trade. That is to say, the purchasing power parity theory applies at best only to current account transactions neglecting capital account completely. Kindleberger states that the purchasing power parity theory is designed for trading nations and gives little guidance to a country which is both a trader and a banker.

10.It unrealistically assumes exchange rate to be a passive variable: The theory assumes that changes in price level could bring about changes in exchange rates and not vice versa, that the changes in exchange rates cannot affect domestic price levels of the countries concerned. This is not correct.

11.The theory applies to a stationary world: Changes in economic relations between two countries are ignored by the theory. It fails to take into account that the equilibrium exchange rate might also change following changes in economic relations between two countries, although price levels may remain unchanged, for instance, when the flow of trade between the original two countries will be affected, influencing the rate of exchange.

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