Foreign Exchange Rate

The foreign exchange rate or exchange

rate is the rate at which one currency is
exchanged for another. It is the price of one
currency in terms of another currency. The
exchange rate is determined in the foreign
exchange market on the basis of demand
for and supply of foreign currencies.
The Foreign exchange market
It is a market where foreign exchange is
bought and sold. It performs three
functions

Key players
Central
bank
Brokers
Commercial banks
Exporters, importers,
tourists investors and
immigrants

Kinds of foreign exchange

market
Spot market Selling and buying of
foreign currency on the spot is spot
market. Settlement is done within
two days.
Forward market When buyers and
sellers enter an agreement to buy
and sell a foreign currency after 90
days of deal, it is called forward
transactions.

Some concepts
Hedging
Importers and exporters enter into an
agreement to sell and buy goods at some future
date at current prices it is called hedging. The
purpose of hedging is to avoid the risk arising from
fluctuations in the exchange rate.
Arbitrage foreign currencies are purchased in
market where the prices are less and sold in the
market where the prices are high. It serves as an
equalizer and stabilizer of exchange rates in major
exchange markets.
Speculation speculators expectations about rise
and fall in prices of foreign exchange rates. Bears
expect the prices will fall. Bulls expect it will rise.
who gains depends on how correct are their
expectations .

Determination of Exchange
rate
The exchange rate in a free market is
determined by the demand for and
the supply of foreign exchange. The
equilibrium exchange rate is the rate
at which the demand for foreign
exchange equals to supply of foreign
exchange. Ragner Nurkse that rate
which over a certain period of time,
keeps the balance of payments in
equilibrium.

Determination of Exchange
rate
Demand for foreign exchange is derived
from demand for foreign goods, services
and securities. And from speculators and
monetary authorities. There is inverse
relationship between the demand for
foreign exchange and the exchange rate.
Supply curve supply of foreign
currencies is from exports of goods,
services and capital movement.

Equilibrium exchange rate

D

R
R
O
exchange

B
E

Q
Demand for supply of foreign

Theories of exchange rate

Mint Parity theory
Purchasing power parity theory
Balance of Payments theory
Purchasing Power Parity theory
Theory was developed by Gustav
Cassel in 1920 to determine the
exchange rate between countries on
inconvertible paper currencies. It is
determined by their prices.

Theories of exchange rate

Mint Parity theory
Purchasing power parity theory
Balance of Payments theory
Purchasing Power Parity theory
Theory was developed by Gustav
Cassel in 1920 to determine the
exchange rate between countries on
inconvertible paper currencies. It is
determined by their prices.
there

Purchasing Power Parity theory

The absolute rate of exchange is determined

in terms of absolute prices. A basket of goods
and services can be bought in India for
Rs. 1000 and in the US for $5 .Then the
exchange rate between the two currencies
will be determined
$20 = Rs. 1000
$1 = Rs. 50
Based on the assumption 1. no transport cost
2. no tariffs 3. no subsidies.

Purchasing Power Parity

theory
Relative version
R1 = R0* P1A / P0A / P1B / P0B
Drawbacks
1. Defects in calculating price level
2. Comparison of general price level a difficult proble
3. Not applicable to capital account
4. Difficult to find Base year
5. Structural changes in factors
6. No free trade
7. Neglect of elasticities
8. One sided
9. Static theory
.

Fixed Exchange rates

Fixed or pegged exchange rates all exchange transactions take
place at an exchange rate that is determined by the monetary
authority. It is fixed by legislation or intervention.
Case for fixed exchange rate
1. based on common currency
Encourage long term capital flows.
No fear of currency fluctuations
No adverse effect of speculation
Disciplinary
Best for small countries.
Less inflationary
Certainty
Suitable for common currency areas.
Promotes money and capital markets
Multilateral trade
International monetary co operation.

Case against
1. Heavy burden
2. misallocation of resources
Complex system
Not always possible.
Bop disequilibrium persists
Dependence on international institutions.

Flexible exchange rate

Case for flexible exchange rate

Simple operation
Smoother adjustments
Autonomy of economic policies
Disequilibrium in the Bop
No need of foreign exchange
Removes problem of international liquidity
Effective monetary policy
Economical

Case against flexible exchange rates

1. mal allocation of resources
2. official intervention
No justification
Exchange risks and uncertainity
Encouragement to inflation

Different systems of
exchange rate
Independent floating 35 countries
including USA,UK ,Japan, South Korea
and Brazil follow the system of
independent floating of their
currency.