Determination of Exchange Rate The rate of exchange being a price of national currency in terms of another, is determined in the in the

foreign exchange market in accordance with the general principle of the theory of value that is by the interaction of forces of DEMAND and !""#$%& Equilibrium Rate of Exchange The e'uilibrium or normal rate of exchange is determined differently under different monetary standards% The market rate of exchange will reflect the temporary influences of forces of demands and supply in a foreign exchange market, but it will be oscillating around the normal rate of exchange% The e'uilibrium rate of exchange is the rate of exchange at which the par value of home currency with foreign currency is maintained at a stable level over a long period of time% Theories for E'uilibrium (ate of Exchange I. Mint Parity Theory II. Purchasing Power Theory I. Mint Parity Theory )hen the currencies of two countries are on a metallic standard *gold or silver+ ,the rate of exchange between them is determined on the basis parity of mint ratios between the currencies of two countries %Thus ,the theory explaining the determination exchange rate between countries which are on the same standard *say, gold coin + is known as the mint parity theory of foreign exchange rate% Thus ,the theory explaining the determination of exchange rate between countries which are on the same standard *say, gold coin + is known as the mint parity theory of foreign exchange rate% Eg, before )orld )ar-., England and America were simultaneously on a full-fledged /old tandard% /old overeign *"ound+ 0 112%3314 grains of /old /old Dollar 0 52%5533 grains of /old 678 0 112%3314752%5533 61 0 89%:44; Assumptions of the Theory 1+ The price of gold is fixed by a country in terms of its currency% 5+ .t buys and sells gold in any amount at that price% 2+ .ts supply of money consists of gold or paper currency which is backed by gold% 9+ .ts price level varies directly with its money supply% ;+ There is movement of gold between countries% 4+ <apital is mobile within countries% =+ The ad>ustment 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is automatic% Criticism, Today, however the method of determining currency value in terms of gold content parity is obsolete for the obvious reasons that,i+ None of the modern countries in the world is on gold or metallic standard% ii+ ?ree buying and selling of gold internationally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 ?iat currency system% iv+ This theory assumes flexibility of internal prices, but modern governments follow independent domestic price policy unrelated to fluctuations in exchange rate% III. Balance of Payment Theory IV. Interest Rate Parity Theory

II. Purchasing Power Parity (PPP Theory <assel suggested purchasing power parity as the appropriate level at which to set the exchange rate% Princi!le The basic principle underlying the purchasing power parity theory is that foreign exchange *foreign money+ is demanded by the nationals of a country because it has the power to command goods *purchasing power+ in its own country *the foreign country+% .t follows that the main factor determining the exchange rate is the relative purchasing power of the two currencies% Thus, the e'uilibrium rate of exchange should be such that the exchange of currencies would involve the exchange of e'ual amounts of purchasing power% @ence, it is the parity *e'uality+of the purchasing power of the currencies which determined the exchange rate% Two Aersions, 1% Absolute or Positive Version: A bundle of /oods 0 813 A bundle of /oods 0 (s% 933 8130(s933 810(s%93 <riticism,a+ ?irstly 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+ econdly, the goods produced and demanded in two different countries are not of the same kind and 'uality, therefore the Be'ualiCation of goods prices - internal purchasing power of two currencies B cannot be envisaged% c+ As a matter of fact, the relative price structure between two B countries cannot be identical on account of differences in 'ualities and characteristics of goods and services, differences in demand patterns, differences in technology, influence of transport costs , differ-ring tariff policies ". Com!arati#e $ersion%& *price index in current period 7 price index in the base period+ in the home country *price index in current period7 price index in the base period+ in the foreign country Criticisms of the Purchasing Power Parity Theory i+ .t is Difficult to Measure Accurately the "urchasing of the <urrency !nits of the Two <ountries ii+ .t Neglects the <ost of Transportation iii+ .t Neglects the "rice of /oods iv+ .t Does Not tudy Dther Elements )hich .nfluence the Ealance of "ayments v+ The changes in the (ate of Exchange .nfluence the "rice #evel vi+ This theory is contrary to /eneral Experience vii+ This Theory does not explain the Demand of ?oreign <urrencies viii+ This theory assumes a /iven (ate of Exchange ix+ This Theory is Eased on a )rong <onception of Elasticity of Demand x+ The theory offers only a #ong Term Explanation of the (ate 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% .t 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%

III. 'alance of Payment Theory Also known as Demand and u!!ly theory of Exchange (ate% DemandF G Aalue of <urrencyF DemandH G Aalue of <urrency H The extent of the demand or the supply of a countryIs currency in the foreign exchange market depends on the balance of payment position% E'uilibrium ED", upply0Demand Deficit ED", upplyJDemand, External Aalue of <urrency H urplus ED", upplyKDemand, External Aalue of <urrency F Merits .t provides an explanation of the determination of demand and supply schedules of a currency in the foreign exchange market% ?or 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 >ust 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 ad>usted through various policy measures% The theory is able to accommodate unilateral capital movements irrespective of their nature, duration and magnitude% Thus, it explicitly recogniCes the fact that rate of exchange is sub>ect to diverse pressures, including for example , war preparations, servicing of outstanding foreign debts, speculative flights of capital and so on% Demerits 1% .t 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% 5% The theory does not explain what determines the internal value of a currency% ?or this we have to resort to purchasing power parity theory% 2% .t unrealistically assumes the balance of payments at a fixed 'uantity% 9% According to the theory, there is no causal connection between the rate of exchange and the internal price level% Eut, in fact , there should be such connection , as the balance of payments position may be influenced by the price cost structure of the country% ;% The theory is indeterminate at a time% .t states that the balance of payments determines the rate of exchange% @owever, the balance of payments itself is a function of the rate of exchange% Thus, there is a tautology, what determines what, is not clear% I$. Interest Rate Parity Theory The .(" theory states that e'uilibrium is achieved when the forward rate differential is approximately e'ual to the interest rate differential% ? 0 L M*1L(h 71L(f + -1N e%g%, (.ND.A 0 13O P (! 0 =O pot (ate 0 .N( 937 ! D 1 Then, Q3 days ?orward (ate 0 93 L 179M*1%1371%3=+ - 1N ? 0 (s% 93%5:7! D

Causes of Changes ( )luctuations In Exchange Rates ". Trade Movements #. $a!ital Movements %. toc& '(change )!eration *. !eculative Transactions +. Ban&ing )!erations ,. Monetary Policy -. Political $onditions .. Inflation Rates /. Interest Rates "0. 'conomic 1rowth "". Political 2 'conomic Ris& "#. $hanges in 3uture '(!ectations "%. 1overnment Intervention )oreign Exchange Rate Policy I. 3i(ed '(change Rate *rguments for )ixe+ Exchange Rate% ". Ris& of 4ncertainty #. Monetary and 3iscal Disci!line %. $onvenience *. 5eed +. ource of 'conomic Benefit 4% 6istorical Relevance -. Prevents $a!ital )utflow :% Promotes $a!ital Movements *rguments against )ixe+ Exchange Rate% ". Domestic tability #. $urbing $om!arative Mar&et 3orces %. $hoice of Rate *. Transient 5ature +. 'conomic $ost of $ontrol ,. Retarding Trade and $a!ital 3lows II. )lexible Exchange Rate *rguments for )lexible Exchange Rate% ". hoc& Absor!tion #. 'ffectiveness of Monetary and 3iscal Policy %. Balance of Payment Ad7ustment *. 3oreign '(change Reserves *rguments against )lexible Exchange Rate% ". Ris& to the 'conomy #. Business Ris& %. Money u!!ly