ECONOMICS Exchange Rate Determination

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<ul><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 1/21</p><p>EXCHANGE RATE</p><p>DETERMINATION</p><p>Prepared By</p><p>Mariya Jasmine M Y</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 2/21</p><p>FOREIGN EXCHANGE</p><p> Popularly referred to as "FOREX"</p><p> The conversion of one country's currency into</p><p>that of another.</p><p> It is the minimum number of units of one</p><p>countries currency required to purchase one</p><p>unit of the other countries currency.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 3/21</p><p>WHY IT NEEDED???.....</p><p> Different countries have different currencies withdifferent values.</p><p>Example: India - Rupees</p><p>America -DollarChina - Yuan</p><p> When trade takes place..</p><p>the persons of these countries have toconvert their currencies to other countriescurrencies to make payments</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 4/21</p><p> For this purpose the concept of foreign</p><p>exchange come into operation.</p><p> Under mechanism of international payments,</p><p>the currency of a country is converted in to</p><p>the currency of another country through</p><p>FOREIGN EXCHANGE MARKET.</p><p> The effect of globalization and international</p><p>trade</p><p> Increased import and export</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 5/21</p><p>FOREIGN EXCHANGE MARKET</p><p> Also called FOREX market.</p><p> It is the place were foreign moneys were</p><p>bought and sold.</p><p> It involves the buying of one currency and</p><p>selling of another currency simultaneously.</p><p>Exchange rates are determined here. Has no geographical boundaries..</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 6/21</p><p>FOREIGN EXCHANGE RATE</p><p> It is the rate at which one currency will beexchanged for another in foreign exchange.</p><p> It is also regarded as the value of one</p><p>countrys currency in terms of anothercurrency.</p><p>There are three basic types;</p><p>Fixed rate</p><p>Floating rate</p><p>Managed rate</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 7/21</p><p>FIXED EXCHANGE RATE</p><p> It is the system offollowing a fixed rate for</p><p>converting currencies.</p><p> In this system, the government (or the central</p><p>bank acting on its behalf) intervenes in the</p><p>currency market in order to keep the exchange</p><p>rate close to a fixed target.</p><p> It does not allow major fluctuations from the</p><p>central rate.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 8/21</p><p>Advantages</p><p> It provide the stability of exchange rate.</p><p>Fixed rates provide greater certainty forexporters and importers.</p><p>Disadvantages Too rigid to take care of major upheavals.</p><p> Need large reserves to defend the fixedexchange rate.</p><p> May cause destabilizing speculations; mostcurrency crisis took place under a fixedexchange system.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 9/21</p><p>FLOATING/FLEXIBLE</p><p>EXCHANGE RATE</p><p> Under the flexible exchange rate system, the</p><p>rate of exchange is allowed to vary to suit the</p><p>economic policies of the government.</p><p> Flexible exchange rates are exchange rates,</p><p>which fluctuate according to market forces.</p><p> The value of the currency is determined solely</p><p>by the forces of demand and supply in the</p><p>exchange market.(self correcting mechanism)</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 10/21</p><p> Advantages</p><p>Automatic adjustmentfor countries with alarge balance of payments deficit.</p><p>Flexibility in determining interest rates</p><p>Allow countries to maintain independenteconomic policies.</p><p>Permit a smooth adjustment to externalshocks.</p><p>Don't need to maintain large internationalreserves.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 11/21</p><p>Disadvantages</p><p>Flexible exchange rates are highly unstable so</p><p>that flows of foreign trade and investmentmay be discouraged.</p><p>They are inherently inflationary.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 12/21</p><p>MANAGED EXCHANGE RATE</p><p> Managed exchange rate systems permit thegovernment to place some influence on anexchange rate that would otherwise be freely</p><p>floating. Managed means the exchange rate system has</p><p>attributes of both systems.</p><p>Through such official interventions it ispossible to manage both fixed and floatingexchange rates.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 13/21</p><p>Simple Mechanism of Demand &amp;</p><p>Supply</p><p> As stated earlier exchange rate is determinedby its the forces of supply and demand.</p><p> Therefore, if for some reason people increase</p><p>their demand for a specific currency, then theprice will rise provided that the supplyremains stable.</p><p>On the contrary, if the supply is increased theprice will decline and it is provided that thedemand remains stable.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 14/21</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 15/21</p><p>Purchasing Power Parity Theory (PPP Theory)</p><p> Most widely accepted theory</p><p>According to PPP theory, when exchange ratesare of a fluctuating nature, the rate of exchange</p><p>between two currencies in the long run will befixed by their respective purchasing powers intheir own nations.</p><p> 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.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 16/21</p><p> This rule is also known as the law of one price.</p><p>It is an economic theory that estimates theamount of adjustment needed on the</p><p>exchange rate between countries in order for</p><p>the exchange to be equivalent to each</p><p>currency's purchasing power.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 17/21</p><p>The Balance of Payment Theory</p><p> The balance of payments approach is another methodthat explains what the factors are that determine thesupply and demand curves of a countrys currency.</p><p> 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.</p><p> The transactions recorded are divided into four</p><p>categories: the current account transactions, thecapital account transactions, financial account and thecentral bank transaction.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 18/21</p><p>CURRENT ACCOUNT</p><p>export and import of goods &amp;services</p><p>CAPITAL ACCOUNT</p><p>Capital transfersFINANCIAL TRANSFERS</p><p>Foreign direct investmentPortfolio investment</p><p>RESERVEBANK TRANSACTIONS</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 19/21</p><p> 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</p><p>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.</p><p>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</p><p>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.</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 20/21</p><p>DETERMINANTS OF FOREIGN</p><p>EXCHANGE RATE</p><p>1. Interest Rate</p><p>Whenever there is an increase interest rates in domestic</p><p>market there will be increase investment funds causing a</p><p>decrease in demand for foreign currency and an increase insupply of foreign currency.</p><p>2. Inflation Rate</p><p>when inflation increases there will be less demand for</p><p>local goods (decreased supply of foreign currency) and more</p><p>demand for foreign goods (increased demand for foreign</p><p>currency).</p></li><li><p>7/28/2019 ECONOMICS Exchange Rate Determination</p><p> 21/21</p><p>3. Government budget deficit or surplus</p><p>The market usually react negatively to widening govt.</p><p>budget deficits and positively to narrowing budget</p><p>deficits. This will result in change in the value of</p><p>countries currency.</p><p>4. Political conditionsInternal, regional and international political</p><p>conditions and events can have a profound effect</p><p>on currency market</p></li></ul>

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