Foreign exchange market

International trade Chapter -7 Lecture- 6

Determination of exchange rates

Meaning of foreign exchange rate
It is the price of one currency in terms of others. It is the rate at which exports and imports of a nation are valued at a given point in time.

Foreign exchange market

It is the market where the national currencies are traded for one another. It performs mainly three functions: 1. To transfer the purchasing power between countries. 2. To provide credit channels for foreign trade. 3. To protect against foreign exchange rate.

Foreign exchange market

Who needs foreign exchange market?
When people wish to operate in the foreign exchange market they intend to buy or sell foreign exchange depending on their demand for and supply of foreign exchange.

Foreign exchange market

Demand side People desire to have or acquire foreign exchange for the following reasons:

1. To purchase goods and services from other countries. 2. To send a gift aboard or make a visit aboard. 3. To purchase financial assets in a particular country 4. To speculate on the value of foreign currencies.

Foreign exchange market

Supply side Foreign currencies flow into economy due to the following:
the domestic

1. Foreigners purchasing home ,countries goods and services through export. 2. Joint venture or through financial market operations. 3. Currency dealers and speculators. 4. Visiting domestic territory and sending gift.

Determination theory
exchange rate movements affect a nation's trading relationships with other nations. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets.

Purchasing power parity (PPP)

1. Purchasing power parity (PPP) is an economic theory and a technique used to determine the relative value of currencies estimating the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to (or on par with) each currency's purchasing power. It asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate. Using that PPP rate, an amount of money thus has the same purchasing power in different countries.

Purchasing power parity (PPP)

The relative version of PPP is calculated as: S= P1/P2 Where: "S" represents exchange rate of currency 1 to currency 2 "P1" represents the cost of good "x" in currency 1 "P2" represents the cost of good "x" in currency 2

Interest rates
2. The international Fisher effect is a hypothesis in international finance that suggests differences in nominal interest rates reflect expected changes in the spot exchange rate between countries.

The hypothesis specifically states that a spot exchange rate is expected to change equally in the opposite direction of the interest rate differential; thus, the currency of the country with the higher nominal interest rate is expected to depreciate against the currency of the country with the lower nominal interest rate, as higher nominal interest rates reflect an expectation of inflation

Interest rates
The Fisher equation is r= R-I This means, the real interest rate (r) equals the nominal interest rate (R) minus expected inflation rate(I)

Interest rates
The nominal interest rate is the interest rate you hear about at your bank. If you have a savings account for instance, the nominal interest rate tells you how fast the number of dollars in your account will rise over time. The real interest rate corrects the nominal interest rate for the effect of inflation in order to tell you how fast the purchasing power of your savings account will rise over time. Real interest rate = Nominal Interest Rate - Expected Inflation Rate Nominal Interest Rate = Real interest Rate + Expected Inflation Rate

Other considerations
3. Confidence in the currency-saving tendency by customer. 4. Technical factors- seasonal demand for currency, the slight strengthening of a currency followed by a prolonged weakness etc.

Exchange control methods

Meaning of exchange control methods: exchange control refers to a governments inter in the foreign exchange market. In other words, it means legal restrictions on the business involving foreign exchange and its sale and purchase in the national market. It is government domination in the foreign exchange market. In the words of Haberler, Exchange control is the state regulation excluding the free play of economic forces from the free play of foreign exchange market Summing up, exchange control is a, method of influencing international trade, investment and the payments mechanism.

Methods
Methods or Devices of Exchange Control. There are large numbers of methods or devices of exchange control. Broadly, these methods are grouped under two main heads. (A) Unilateral Methods and (B) Bilateral or Multilateral Method

Unilateral Methods
(A)Unilateral methods are those methods of exchange control which are adopted by the government of a country without any consultation or understanding with any other country. The main methods under this head are as follows: 1. Exchange pegging. 2. Exchange Equalization Account. 3. Clearing Agreement 4. Stand still Agreement. 5. Compensation Agreement.

Unilateral Methods
6. Blocked Accounts. 7. Payment Agreements. 8. Rationing of Foreign exchange 9. Multiple Exchange Rates

Bilateral or Multilateral Methods

(B) Bilateral or Multilateral Methods. When two or more than two countries decide to adopt certain measures for stabilizing the rates of exchange between them, these are called bilateral or multilateral methods. The main methods are:1. Clearing Agreements. 2. Transfer Moratoria 3. International Liquidity.