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related to the price of foreign currency Supply of foreign currency positively related to the price of foreign currency Forces of demand and supply together determine the exchange rate
D $2.00 $1.50 D
50m 75 m Units of Foreign Currency ()
$2.00
$1.50 S
50 m 75 m Units of Foreign Currency ()
$1.6775
D
Units of Foreign Currency()
e.g., before World War-I, England and America were simultaneously on a full-fledged Gold Standard.
Gold Sovereign(Pound) = 113.0016 grains of Gold Gold Dollar = 23.2200 grains of Gold
/$ = 113.0016/23.2200 1 = $4.8665
currency. 2) It buys and sells gold in any amount at that price. 3) Its supply of money consists of gold or paper currency which is backed by gold. 4) Its price level varies directly with its money supply. 5) There is movement of gold between countries. 6) Capital is mobile within countries. 7) The adjustment mechanism is automatic.
Criticism
Today, however the method of determining currency value in terms of gold content parity is obsolete for the obvious reasons that: i) None of the modern countries in the world is on gold or metallic
standard. ii) Free buying and selling of gold internationally is not permitted by various governments and as such it is not possible to fix par value in terms of gold content or mint parity . iii) Most of the countries today are on paper standard or Fiat currency system. iv) This theory assumes flexibility of internal prices, but modern governments follow independent domestic price policy unrelated to fluctuations in exchange rate.
Two Versions:
1. Absolute or Positive Version: A bundle of Goods = $10 A bundle of Goods = Rs. 400 $10=Rs400 $1=Rs.40 Criticism: a) Firstly though the absolute version appears to be very elegant arid simple it is totally useless because it measures the absolute levels of internal prices .And we know that the value (or purchasing power) of money cannot be measured in terms .
b) Secondly, the goods produced and demanded in two different countries are not of the same kind and quality, therefore the equalization of goods prices - internal purchasing power of two currencies cannot be envisaged.
c) As a matter of fact, the relative price structure between two countries cannot be identical on account of differences in qualities and characteristics of goods and services, differences in demand patterns, differences in technology, influence of transport costs , differ-ring tariff policies
2. Comparative Version:(price index in current period / price index in the base period) in the home country (price index in current period/ price index in the base period) in the foreign country
Currency Units of the Two Countries ii) It Neglects the Cost of Transportation iii) It Neglects the Price of Goods iv) It Does Not Study Other Elements Which Influence the Balance of Payments v) The changes in the Rate of Exchange Influence the Price Level vi) This theory is contrary to General Experience vii) This Theory does not explain the Demand of Foreign Currencies viii) This theory assumes a Given Rate of Exchange ix) This Theory is Based on a Wrong Conception of Elasticity of Demand x) The theory offers only a Long Term Explanation of the Rate of Exchange
Despite the above critics, the theory has not lost its importance which will be obvious from the following points: i) This theory very clearly tells us that how the rate of exchange between two counties on inconvertible paper currency standard determined. It also establishes a close relationship between the internal price level and the rate of exchange of a country. ii) This theory is applicable to all sorts of monetary standards. iii) This theory also explains the state of the trade of a country as well as the nature of its balance of payments at a particular time. iv) This theory also explains how the foreign trade and the rate of exchange of a country are affected by the depreciation and appreciation of its currency.
Merits
It provides an explanation of the determination of demand and supply schedules of a currency in the foreign exchange market. For this reason, it is better than those theories which ignore this explanation.
The theory is more realistic in the sense that the domestic price of a foreign currency is seen as a function of many significant variables, not just its purchasing power expressing general price levels. The theory can be extended to incorporate the fact that balance of payment of a country is influenced by several factors, and may also be adjusted through various policy measures.
The theory is able to accommodate unilateral capital movements irrespective of their nature, duration and magnitude. Thus, it explicitly recognizes the fact that rate of exchange is subject to diverse pressures, including for example , war preparations, servicing of outstanding foreign debts, speculative flights of capital and so on.
Demerits
1. It assumes perfect competition and non intervention of the government in the foreign exchange market. This is not very realistic in the present day of exchange controls.
2. The theory does not explain what determines the internal value of a currency. For this we have to resort to purchasing power parity theory. 3. It unrealistically assumes the balance of payments at a fixed quantity. 4. According to the theory, there is no causal connection between the rate of exchange and the internal price level. But, in fact , there should be such connection , as the balance of payments position may be influenced by the price cost structure of the country. 5. The theory is indeterminate at a time. It states that the balance of payments determines the rate of exchange. However, the balance of payments itself is a function of the rate of exchange. Thus, there is a tautology, what determines what, is not clear.
F = Rs. 40.28/USD
1. Trade Movements
2. Capital Movements 3. Stock Exchange Operation 4. Speculative Transactions 5. Banking Operations
6. Monetary Policy
7. Political Conditions
8. Inflation Rates
9. Interest Rates 10. Economic Growth 11. Political & Economic Risk 12. Changes in Future Expectations
5.
6. 7.
8.
Risk of Uncertainty Monetary and Fiscal Discipline Convenience Need Source of Economic Benefit Historical Relevance Prevents Capital Outflow Promotes Capital Movements
Arguments against Fixed Exchange Rate: 1. Domestic Stability 2. Curbing Comparative Market Forces 3. Choice of Rate 4. Transient Nature 5. Economic Cost of Control 6. Retarding Trade and Capital Flows