exchange rate determination-

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Exchange RateDetermination

Unit 3Chapter 3


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Introduction

An Exchange rate is the price of one nationscurrency in terms of another currency, often

termed as the reference currency. E.g. the rupee/dollar exchange rate is just the

number of Rupees that one dollar will buy if a dollar will buy 100 Rupees then the exchange

rate could be expressed as Rs.100/$ and Rupees

will be the reference currency.. Similarly, the dollar/Rupees exchange rate is thenumber of dollars one Rupees will buy followingthe same example the exchange rate would be$0.01/Rs.


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When a currency becomes more

valuable relative to another currencyit is said to be appreciated. The priceof the foreign exchange has fallen(e.g. 1 USD buys Rs. 45 instead of

Rs. 39 earlier). When a currency becomes less

valuable relative to another currency,

it is said to be depreciated. The priceof the forei n exchan e has risen


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Exchange Rate Determination

It is determined by the equilibrating

interaction of buyers and sellers ofcurrencies in the FOREX market:demand and supply determine

exchange rates. Demandfor a currency for makingpayments for foreign trade and capitalflows.

Supply of a currency, during foreign


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Exchange Rate Equilibrium

An exchange rate represents the

price of a currency, which isdetermined by the demand for thatcurrency relative to the supply for that

currency.


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Exchange Rate Equilibrium

e

D

DS

S

Quantity of Rupees

Value

of

Rupees


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Factors Affecting Exchange

Rate

Relative Inflation

Rate:

U.S. inflation

U.S. demand for

Indian goods, andhence Rs.

Indian desire for

U.S. goods, and

Relative Interest

Rate:

U.S. interest rates

U.S. demand for

Indian bankdeposits, andhence demand forRs.

Indian desire for


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Factors contd..

Relative IncomeLevels:

U.S. income level U.S. demand for

Indian goods, andhence Rs.

No expected changefor the supply of Rs.

Political and EconomicRisk:

Investors prefer to holdlesser amounts of riskierassets, thus, low riskcurrenciesthoseassociated with more

politically andeconomically stablenationsare morehighly valued than highrisk currencies.


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PPP theory

Given by Gustav Cassel.

According to this theory, the pricelevels and the changes in the pricelevels in different countries determinethe exchange rates of these countrys

currencies. This theory is based on the principle

that the exchange rates between

various currencies reflect the


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PPP THEORY contd..

assumptions of Law of One Price are:

There is no restriction on the movementof goods between countries.

There is no transportation cost involved.

There is no transaction cost involved inthe buying and selling of goods.

There are no tariffs involved.

Example: US/French exchange rate: $1 =

.78Eur A jacket selling for $50 in New


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PPP THEORY contd..

According to this theory, the price of a commodityshould remain the same across the world. If notthen arbitrageurs would buy from cheaper marketand sell them in dearer market till price wouldbecome same in both countries/markets.

Another way to explain it is, that in equilibriumwhere domestic purchasing powers at the rate ofexchange are equivalent.

Therefore, the rate of exchange tends to rest atthat point which expresses equality between therespective purchasing powers of the twocurrencies. This point is called Purchasing PowerParity.


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PPP THEORY contd..

Reasons why PPP is not perfect:

PPP numbers can vary with the specificbasket of goods used, making it a roughestimate.

Preferences and choices can vary fromcountry to country. Goods then differ intheir contribution to welfare.

International competitiveness is mainly

affected by the exchange rate and not

exchange rate determination-

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