meaning and calculation of foreign exchange by sanya juneja pgdim 11-12

8/2/2019 Meaning and Calculation of Foreign Exchange by Sanya Juneja Pgdim 11-12

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MEANING AND

CALCULATION OF

FOREIGN EXCHANGE

SANYA JUNEJAPGDIM 11-12

Roll no. 38



The fact that all open economies are economicallyinterlinked and independent to some extent gives

rise to the concept of foreign exchange.

It is the rate at which currency of a country can be

bought and sold against the currency of anothercountry in the foreign exchange market

Example: US $= Rs 44.60 ( 1 US $ can bepurchased for 44.60 INR)



DETERMINATION OF FOREIGNEXCHANGE RATE IN A

FREE MARKET



DD1 shows Inverse relation between demandfor foreign exchange and exchange rate.

Equilibrium Exchange rate : $1= Rs.50, the

intersection of DD1

and SS’ at point P.



In case, $ increases for some reason, say,

increase in demand for the US goods,DD1 shifts out to DD2

•New Equilibrium Exchange rate : $1= Rs.60, theintersection of DD2 and SS’ at point P’.

Thus market will be cleared at $12.5 million.



PURCHASING POWER PARITY THEORY

This asserts that relative value of differentcurrencies correspond to the relation betweenthe real purchasing power of each currency in itsown country.

Eg; suppose a basket of goods and services canbe bought in India for Rs.100 and in US for $2,

then absolute exchange rate will be:$2 = Rs 100

or $1 = Rs 50



Absolute exchange rate is unrealistic as itassumes:

* no cost of transportation* no tariffs and no subsidies

thus, relative exchange rate emerged.

Relative purchasing power parity determines theexchange rate between any two currencies with

changing prices. Because it takes into accountthe inflation rates and other factors causing achange in price levels.



P0A and P0B : price levels in countries A and B inyear 0.

P1A and P1B : price levels in countries A and B inyear 1.

R0 : exchange rate between the two currencies

in year 0. then the exchange rate R1 in year 1 is :

R1 = R0 P1A/P0A

P1B/P0B



PPP theory can be used as the firstapproximation of an equilibrium rate of

exchange for periods of serious and frequentprice changes.

However, for a more accurate measure of the

exchange rate , other factors like• Capital transfers

• Changes in production techniques

•

Changes in real incomes ,needs to be accounted for .

meaning and calculation of foreign exchange by sanya juneja pgdim 11-12

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