EXCHANGE RATE DETERMINATION Chapter 02

FOREIGN EXCHANGE Popularly referred to as "FOREX" The conversion of one country's currency into that of another. It is the minimum number of units of one countries currency required to purchase one unit of the other countries currency.

WHY IT NEEDED???..... Different countries have different currencies with different values…. Example: India - Rupees America -Dollar China - Yuan When trade takes place….. the persons of these countries have to convert their currencies to other countries currencies to make payments For this purpose the concept of foreign exchange come into operation. Under mechanism of international payments, the currency of a country is converted in to the currency of another country through FOREIGN EXCHANGE MARKET.

FOREIGN EXCHANGE MARKET Also called “FOREX” market. It is the place were foreign moneys were bought and sold. It involves the buying of one currency and selling of another currency simultaneously. Exchange rates are determined here…. Has no geographical boundaries…..

FOREIGN EXCHANGE RATE It is the rate at which one currency will be exchanged for another in foreign exchange. It is also regarded as the value of one country’s currency in terms of another currency. There are three basic types; 1. Fixed rate 2. Floating rate 3. Managed rate

1. FIXED EXCHANGE RATE It is the system of following a fixed rate for converting currencies. In this system, the government (or the central bank acting on its behalf) intervenes in the currency market in order to keep the exchange rate close to a fixed target. It does not allow major fluctuations from the central rate.

It provide the stability of exchange rate. Advantages It provide the stability of exchange rate. Fixed rates provide greater certainty for exporters and importers. Disadvantages Too rigid to take care of major upheavals. Need large reserves to defend the fixed exchange rate. May cause destabilizing speculations; most currency crisis took place under a fixed exchange system.

2. FLOATING/FLEXIBLE EXCHANGE RATE Under the flexible exchange rate system, the rate of exchange is allowed to vary to suit the economic policies of the government. Flexible exchange rates are exchange rates, which fluctuate according to market forces. The value of the currency is determined solely by the forces of demand and supply in the exchange market.(self correcting mechanism)

Advantages Automatic adjustment for countries with a large balance of payments deficit. Flexibility in determining interest rates Allow countries to maintain independent economic policies. Permit a smooth adjustment to external shocks. Don't need to maintain large international reserves. Disadvantages: Flexible exchange rates are highly unstable so that flows of foreign trade and investment may be discouraged. They are inherently inflationary.

3. MANAGED EXCHANGE RATE Managed exchange rate systems permit the government to place some influence on an exchange rate that would otherwise be freely floating. Managed means the exchange rate system has attributes of both systems. Through such official interventions it is possible to manage both fixed and floating exchange rates.

Simple Mechanism of Demand & Supply As stated earlier exchange rate is determined by its the forces of supply and demand. Therefore, if for some reason people increase their demand for a specific currency, then the price will rise provided that the supply remains stable. On the contrary, if the supply is increased the price will decline and it is provided that the demand remains stable.

Purchasing Power Parity Theory (PPP Theory) Most widely accepted theory “According to PPP theory, when exchange rates are of a fluctuating nature, the rate of exchange between two currencies in the long run will be fixed by their respective purchasing powers in their own nations.” i.e the price of a good that is charged in one country should be equal to the one charged for the same good in another country, being exchanged at the current rate.

The Balance of Payments (BOP) Approach The relationship between the BOP and exchange rates can be illustrated by the use of a simplified equation that summarizes BOP data: (X – M) + (CI – CO) + (FI – FO) + FXB = BOP Where X = exports of goods and services, M = imports of goods and services, CI = capital inflows, CO = capital outflows, FI = financial inflows, FO = financial outflows and FXB = official monetary reserves. Current Account Balance Capital Account Balance Financial Account Balance Reserve Balance Balance of Payments

The Balance of Payments (BOP) Approach Fixed Exchange Rate Countries: Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. To ensure a fixed exchange rate, the government must intervene in the foreign exchange market and buy or sell domestic currencies (or sell gold) to bring the BOP back to near zero. It is very important for a government to maintain significant foreign exchange reserve balances to allow it to intervene in the foreign exchange market effectively.

The Balance of Payment Approach The balance of payments approach is another method that explains what the factors are that determine the supply and demand curves of a country’s currency. As it is known from macroeconomics, the balance of payments is a method of recording all the international monetary transactions of a country during a specific period of time. The transactions recorded are divided into four categories: the current account transactions, the capital account transactions, financial account and the central bank transaction.

CURRENT ACCOUNT export and import of goods &services CAPITAL ACCOUNT Capital transfers FINANCIAL TRANSFERS Foreign direct investment Portfolio investment RESERVEBANK TRANSACTIONS

According to the theory, a deficit in the balance of payments leads to fall or depreciation in the rate of exchange, while a surplus in the balance of payments strengthens the foreign exchange reserves, causing an appreciation in the price of home currency in terms of foreign currency. A deficit balance of payments of a country implies that demand for foreign exchange is exceeding its supply. As a result, the price of foreign money in terms of domestic currency must rise, i.e., the exchange rate of domestic currency must fall. On the other hand, a surplus in the balance of payments of the country implies a greater demand for home currency in a foreign country than the available supply. As a result, the price of home currency in terms of foreign money rises, i.e., the rate of exchange improves.

DETERMINANTS OF FOREIGN EXCHANGE RATE Interest Rate Whenever there is an increase interest rates in domestic market there will be increase investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency. Inflation Rate when inflation increases there will be less demand for local goods (decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).

Government budget deficit or surplus The market usually react negatively to widening govt. budget deficits and positively to narrowing budget deficits. This will result in change in the value of countries currency. Political conditions Internal, regional and international political conditions and events can have a profound effect on currency market