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7/28/2019 ECONOMICS Exchange Rate Determination

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EXCHANGE RATE

DETERMINATION

Prepared By

Mariya Jasmine M Y


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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.


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WHY IT NEEDED???.....

Different countries have different currencies withdifferent values.

Example: India - Rupees

America -DollarChina - Yuan

When trade takes place..

the persons of these countries have toconvert their currencies to other countriescurrencies to make payments


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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.

The effect of globalization and international

trade

Increased import and export


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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..


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FOREIGN EXCHANGE RATE

It is the rate at which one currency will beexchanged for another in foreign exchange.

It is also regarded as the value of one

countrys currency in terms of anothercurrency.

There are three basic types;

Fixed rate

Floating rate

Managed rate


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FIXED EXCHANGE RATE

It is the system offollowing 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.


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Advantages

It provide the stability of exchange rate.

Fixed rates provide greater certainty forexporters and importers.

Disadvantages Too rigid to take care of major upheavals.

Need large reserves to defend the fixedexchange rate.

May cause destabilizing speculations; mostcurrency crisis took place under a fixedexchange system.


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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)


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Advantages

Automatic adjustmentfor countries with alarge balance of payments deficit.

Flexibility in determining interest rates

Allow countries to maintain independenteconomic policies.

Permit a smooth adjustment to externalshocks.

Don't need to maintain large internationalreserves.


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Disadvantages

Flexible exchange rates are highly unstable so

that flows of foreign trade and investmentmay be discouraged.

They are inherently inflationary.


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MANAGED EXCHANGE RATE

Managed exchange rate systems permit thegovernment to place some influence on anexchange rate that would otherwise be freely

floating. Managed means the exchange rate system has

attributes of both systems.

Through such official interventions it ispossible to manage both fixed and floatingexchange rates.


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Simple Mechanism of Demand &

Supply

As stated earlier exchange rate is determinedby its the forces of supply and demand.

Therefore, if for some reason people increase

their demand for a specific currency, then theprice will rise provided that the supplyremains stable.

On the contrary, if the supply is increased theprice will decline and it is provided that thedemand remains stable.


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Purchasing Power Parity Theory (PPP Theory)

Most widely accepted theory

According to PPP theory, when exchange ratesare of a fluctuating nature, the rate of exchange

between two currencies in the long run will befixed by their respective purchasing powers intheir own nations.

i.e the price of a good that is charged in onecountry should be equal to the one charged forthe same good in another country, beingexchanged at the current rate.


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This rule is also known as the law of one price.

It is an economic theory that estimates theamount of adjustment needed on the

exchange rate between countries in order for

the exchange to be equivalent to each

currency's purchasing power.


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The Balance of Payment Theory

The balance of payments approach is another methodthat explains what the factors are that determine thesupply and demand curves of a countrys currency.

As it is known from macroeconomics, the balance ofpayments is a method of recording all the internationalmonetary transactions of a country during a specificperiod of time.

The transactions recorded are divided into four

categories: the current account transactions, thecapital account transactions, financial account and thecentral bank transaction.


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CURRENT ACCOUNT

export and import of goods &services

CAPITAL ACCOUNT

Capital transfersFINANCIAL TRANSFERS

Foreign direct investmentPortfolio investment

RESERVEBANK TRANSACTIONS


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According to the theory, a deficit in the balance ofpayments leads to fall or depreciation in the rate ofexchange, while a surplus in the balance of payments

strengthens the foreign exchange reserves, causing anappreciation in the price of home currency in terms offoreign currency. A deficit balance of payments of acountry implies that demand for foreign exchange isexceeding its supply.

As a result, the price of foreign money in terms ofdomestic currency must rise, i.e., the exchange rate ofdomestic currency must fall. On the other hand, asurplus in the balance of payments of the countryimplies 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 moneyrises, i.e., the rate of exchange improves.


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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 insupply 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).


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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 conditionsInternal, regional and international political

conditions and events can have a profound effect

on currency market

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