Exchange Rate

The rate at which the currency unit of one country may be exchanged for that of another.
Exchange rate plays a critical role in countrys level of trade. An exchange rate has two
components, the domestic currency and a foreign currency, and can be quoted either directly
or indirectly.
In direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic
currency.
Eg: 1 US Dollar = 60.21 INR
In an indirect quotation, the price of a unit of domestic currency is expressed in terms of the
foreign currency.
Eg: 1 INR = 0.017 USD
Types of exchange rate

Fixed exchange rate: In fixed exchange rate system, the central bank intervenes in
currency market in order to keep currency closed to fixed target. It is committed to a
single fixed exchange rate and does not allow major fluctuations from this central rate.
Free floating exchange rate: The value of the currency is determined solely by supply
and demand in the foreign exchange market. Consequently, trade flows and capital
flows are the main factors affecting the exchange rate. Pure free floating exchange rates
are rare - most governments at one time or another seek to manage the value of their
currency through changes in interest rates and other means of controls.
Pegged exchange rate: A pegged exchange rate system is a hybrid of fixed and floating
exchange rate regimes. Typically, with a pegged exchange rate, an initial target
exchange rate is set and the actual exchange rate will be allowed to fluctuate in a range
around that initial target rate. Also, given changes in economic fundamentals, the target
exchange rate may be modified.
How is exchange rate influenced by demand and supply?

Exchange rate can be volatile as demand and supply depends on various factors.
Demand: If demand for a currency increases keeping supply constant, the currency appreciates.
Supply: Currency depreciates if supply of currency is increased keeping demand constant.
Eg : The purchase of Indian cotton by US industries will result in conversion of US dollars to
Indian rupee thus increasing demand and appreciating rupee relative to dollar. As rupee gets
expensive, demand for cotton decreases thus depreciating the rupee.

Factors affecting exchange rate
Interest Rate: Higher rate of interest makes a country attractive for foreign investors
since it provide higher rate of return compared to other countries. This results in
exchange rate to rise.
Inflation: A country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies.
Current Account Deficit: Current Account Deficit shows that a country is borrowing
capital to make up for the deficit. This excess demand of foreign currency results in
depreciating local currency.
Political and Economical Stability: Foreign investors prefer politically stable and
economically sound countries to invest. Such countries would draw investment funds
from other countries increasing the demand of local currency which results in
appreciating local currency.

Impact of rupee depreciation on Indian economy
Increase in import cost: Depreciation in currency would result in increasing import cost
which would result in increase in current account deficit.
High inflation: As seen in 1
st
point, depreciating rupee causes increase in import cost
and if that increased bill is passed to final consumers it lead to higher inflation. So
depreciating rupee would either result in increase in current account deficit or inflation.
Fiscal Deficit: The increased bill of crude oil and fertilizer might warrant provision for
extra subsidy and government may have to face the brunt of it in form of increasing
fiscal deficit.
Sectors such as Auto, cement, capital goods are worst hit by depreciating currency as they
either depend on imports directly or are exposed to import of crude oil or fertilizers.





The effect of monetary and fiscal policies on exchange rate

Standard macroeconomic principles indicate that expansionary monetary and fiscal policies
increase aggregate demand and output. Expansionary monetary policy affects growth positively
by reducing interest rates and thereby increasing investment and consumption spending.
Expansionary fiscal policy increases spending, either directly or through lower taxes, and
therefore the output is increased in the short term to the medium term. At the same time,
expansionary fiscal policy typically exerts upward pressure on the interest rates as larger
budget deficits need to be financed.

Expansionary monetary policy leads to capital outflows and thereby downward pressure on the
currency. Expansionary fiscal policy should lead to capital inflows and upward pressure on the
exchange rate. This mechanism is called the Mundell-Fleming model, developed in the 1960s.

Let us consider four cases involving fixed and floating exchange rates


Expansionary Monetary Policy with Flexible Exchange Rates: With monetary easing,
the interest rates will face a downward pressure. This will in turn induce capital outflow
to higher yield markets, putting downward pressure on the domestic currency. The
more responsive the capital flows are to the changes in interest rates, the larger the
depreciation of the currency. Depreciation of the currency will increase the net exports
and reinforce the aggregate demand impact of the expansionary monetary policy.

Expansionary Monetary Policy with Fixed Exchange Rates: To prevent the exchange
rate from depreciating, the authority will have to buy its own currency in exchange for
other currencies in the foreign exchange market. Doing so will tighten the domestic
credit conditions due to lesser supply of the domestic currency and therefore offset the
downward pressure due to monetary policy. In the extreme case, expansionary
monetary policy will be rendered completely ineffective by the central banks purchase
of its own currency and the interest rate will be allowed to rise back to its initial level.
The monetary authoritys ability to maintain fixed exchange rate will be limited by their
foreign exchange reserves. Most developing countries have high levels of foreign
exchange reserves.

Expansionary Fiscal Policy with Flexible Exchange Rates: An expansionary fiscal policy
will tend to exert an upward pressure on the interest rates which will in turn induce an
inflow of capital from lower yield markets putting upward pressure on the domestic
currency. If capital flows are highly sensitive to the change in interest rate then the
currency will appreciate substantially. On the other hand if the capital flows are
insensitive to interest rate changes, then the currency will depreciate rather than
appreciate since the increase in aggregate demand worsens the trade balance.

Expansionary Fiscal Policy with Fixed Exchange Rates: To prevent the domestic
currency from appreciating, the monetary authority will sell its own currency in the
foreign exchange market. The expansion of the domestic money supply will reinforce
the aggregate demand impact of the expansionary fiscal policy.

The specific mix of monetary and fiscal policies can have a profound impact on the countrys
exchange rate. If the capital mobility is high, a restrictive monetary policy and an expansionary
fiscal policy will lead to a highly responsive appreciation of the domestic currency. Thus, this
policy is extremely bullish for a currency. Likewise, the combination of expansionary monetary
policy and restrictive fiscal policy is extremely bearish for a currency. In case of conflicting
policies, the effect on currency is ambiguous. Capital mobility tend to be high in developed
countries.

When capital mobility is low (i.e. interest rate changes will not induce any major changes in
capital flow), monetary and fiscal policies will primarily affect trade flows and not capital flows.
Hence, a uniformly restrictive fiscal and monetary policy will be bullish for a currency because it
will tend to an improvement in trade balance. Similarly, a uniformly expansionary
fiscal/monetary policy will be bearish for currency as it will lead to a deterioration in trade
balance. Combinations of fiscal and monetary policy will have an ambiguous effect on the
aggregate demand and thereby on the currency. In emerging market economies, the
movement of capital is restricted and hence this case is applicable to developing countries.

The key insights from Mundell-Fleming framework are as follows:

The three objectives a) independent monetary policies, b) free capital flow across
national borders and c) fixed exchange rates cannot be satisfied at the same time.

The degree of capital mobility is critical to the effectiveness of the monetary and fiscal
policy in an open economy.

Policymakers may need to impose capital controls in order to stabilize the exchange rate
and make monetary policy a viable policy instrument for domestic objectives such as
employment sustainability and price stability.