DETERMINATION OF EXCHANGE RATE

Q. 1 : What is exchange rate? How is it determined?

Ans. A) EXCHANGE RATE
Exchange rate refers to the rate at which a countrys currencies are exchanged for
currencies of other country. In other words it is the price of one currency in terms of another currency.
For Eg. If the value of 1 US dollar in Indian rupees is 45 then the exchange rate is 1 US $ = ` 45. Thus
foreign exchange rate indicates the external value of a countrys currency. It also shows the
purchasing power of a countrys currency in terms of currency of another country.
Overall we can say that the rate of exchange is nothing but the value or price of a
countrys currency expressed in terms of a foreign currency.
B.

DETERMINATION OF EXCHANGE RATE

The rate of exchange being a price of national currency in terms of another, is
determined in foreign exchange market in accordance with general principle of the theory of value
i.e., by the interaction of forces of demand and supply. Thus the rate of exchange in the foreign
exchange market will be determined by interaction between demand for foreign exchange and supply
of foreign exchange.
1. Demand For Foreign Exchange
Foreign exchange is required by citizens or Government to make payments abroad. This
results in demand for foreign exchange. These payments are recorded in payment side of BOP. The
demand for foreign currency arises due to the following payments
A. Import Of Goods
Consumer as well as capital goods are imported from other countries. Foreign exchange
is demanded by people who import these goods. Higher the value of Imports, higher is the demand for
foreign currency.

B. Import of services
Services rendered by other countries which include banking, insurance, transport,
communication, educational services, etc. are required to be paid in foreign exchange.
C. Dividend. Interest And Profits
In India, many foreign firms have invested in various sectors, which results in outflow
of foreign exchange on account of dividend and profits. On other hand Government and Indian firms
have also borrowed from foreign countries, which results in payment of Interest.
D. Unilateral Payments
Donations, gifts etc. are 'one sided payments without corresponding returns. Such
payments create demand for foreign exchange.
E. Export Of Capital
Repayment of debt, purchase of assets in foreign countries etc. all require foreign
exchange.
All the above categories of payments abroad result in aggregate demand for foreign
exchange. The total demand for foreign currency is inversely related to foreign exchange rate. At a
higher exchange rate, the demand for foreign currency may be low. Let us explain with diagram:
The demand curve like an ordinary demand curve is sloping downwards from left to right.
At the rate OR per unit of foreign currency, OQ amount is demanded. More is demanded at a lower
price.
2.

Supply Of Foreign Exchange

Supply of foreign exchange in a country comes from receipts of its exports. The
receipts of foreign currency are recorded in the receipt side of BOP. The main sources of supply are:

A. Exports Of Goods

B.

C.

D.
E.

This constitutes a major source of supply of foreign exchange. Both size and price of
exports depends on demand of elasticity for goods. In India, the manufactured items occupy the top
position in exports.
Exports Of Services
In recent years this source is gaining importance. Expert Services in various fields,
tourists coming from other countries, transport, communication, insurance etc. are important services
which earn and supply foreign exchange.
Dividend, Interest And profits
Indian firms have invested in various sectors in foreign countries. Thus there is inflow
of foreign exchange on account of dividend and profits. Indian institutions also have lent money
abroad, which results in reciept of interest.
Unilateral Receipts
Payments received in form of remittance from domestics working abroad, donations
etc. form a part of foreign exchange supply.
Import Of Capital
Foreign investment - direct and portfolio - repayment of debts by foreigners, all
increase the supply of foreign exchange.
All the above categories of receipts from abroad result in aggregate supply of foreign
exchange. The total supply, like the supply of any other commodity, is directly related to price i.e. the
foreign exchange rate. At a higher exchange rate, the supply of foreign currency may be high. Let us
explain with diagram
The above diagram shows that the supply curve for foreign exchange slopes upwards
from left to right which shows direct relationship between exchange rate and demand for foreign
currency. There is higher supply of foreign currency at higher exchange rate.

3.

Determination Of Exchange Rate I Determination Of Equilibrium Exchange Rate

The foreign exchange rate is determined by demand for and supply of foreign
exchange. The rate established at a point where demand and supply are equal is called equilibrium
rate of exchange. In other words an equilibrium rate of exchange is one Where there is neither a
surplus nor a deficit in balance of payments of a country. Any change in demand and supply will
result in a change in exchange rate.
In the above figure, the equilibrium rate is at E, where demand and supply curves intersect.
OR is equilibrium exchange rate when demand for the exchange is equal to its supply. OR, and
OR2 are not equilibrium exchange rates. At OR1, D > S (i.e. RrM > R,N), and at OR2, S > D (i.e. R2T >
R2P). At R, and R2 exchange rates there will be pressure on the prevailing rate to move towards the
equilibrium exchange rate i.e. towards point E.
Thus exchange rate, like any-other price is determined by demand and supply forces in the
foreign exchange market. Any change in demand and supply will result in change in exchange rate.
Q. 3 : Explain the Purchasing Power Parity Theory.
Write a note on PPP Theory.

OR

Ans. A) PURCHASING POWER PARITY (PPP) THEORY

The Credit of Purchasing Power Parity (PPP) Theory goes to Swedish economist Gustav
Cassel. According to this theory, the exchange rate between two countries is determined by their
purchasing power in terms of goods and services.
The PPP Theory is presented in two versions the Absolute Version and the Relative
Version.

1.

Absolute Version Of PPP

The absolute version of the PPP theory the exchange rates between two currencies of
two different countries is decided by their purchasing power. In other words, the rate of exchange will
be determined at the point where the internal purchasing powers of the two currencies become equal.
Gustav Cassel said that the purchasing power of two different currencies is to be compared only in
terms of a basket of goods & services rather than a single commodity. For eg. a particular basket of
goods cost `. 4,000 in India and $ 100 in U.S.A. That means the exchange rate would be .` 40 = $ 1.
Where :R = Rate of exchange of domestic currency in relation to foreign currency.
P = Prices of certain goods in domestic currency
Po= Prices of same goods in foreign currency.
According to absolute PPP, a rise in domestic price level in relation to foreign price level will
lead to proportional depreciation of domestic currency against foreign currency. For Eg. If the price of
basket of goods in India increases to `. 4,250, while the price of basket in USA remains same, then the
new exchange rate will be
R = 4250 = 42.5 `
100
In the above case, the Indian ` depreciates & US $ appreciates.
2.

Relative Version Of PPP

The relative version of PPP Theory states that the exchange rate will adjust by the amount
of inflation differential between the two countries. According to P.R. Krugman & M.Obstfeld, The
relative PPP states that the percentage change in the exchange rate between two currencies over any
period equals the difference between the percentage changes in national price levels. Here some past
exchange rate is taken as base rate.
Formula:R1 = New Equilibrium exchange rate
R0 = Equilibrium rate in base period.
P1 = New price Index in domestic country.
P2 = New price Index in foreign country.
For Eg The price index in India increases from 100 to 300 & in USA it increased from 100 to 200.The
base rate is 40.
Then the new exchange rate will be
R = 40 x 300 = 60 = (Rs 60=1US $).
200
Q-4. Critically evaluate the Purchasing Power Parity Theory.

OR

Explain the limitations of PPP Theory.

Ans. A) CRITICAL EVALUATION I LIMITATIONS OF PPP THEORY
The Purchasing Power Parity theory has following drawbacks

1.

Ignores Government Intervention

The PPP theory does not consider Government or Central Bank intervention in exchange
rate determination. If domestic currency depreciates or appreciates too much, the central bank
intervenes as it can have adverse effects on economy. Normally, under managed float, the central bank
intervenes in exchange rate.
2.

Ignores Quality Of Goods

PPP ignores quality of goods while determining prices. Quality of goods in two different
countries may be different. This prevents the equalisation of prices thus it is difficult to arrive at
equilibrium exchange rate.
3.

Ignores Specialisation
PPP theory ignores specialisation effect in international trade. Countries specialise in
those items in which they enjoy superior cost advantage and accordingly produce such items. But PPP
theory considers relative purchasing power of currencies for a similar basket of goods and services.
4.

Ignores The Effect Of Change In Exchange Rate On Price Level

PPP theory assumes that changes in price levels lead to changes in exchange rates and it
does not consider the effect of changes in exchange rate on price level. Such an assumption is
unrealistic, as depreciation of domestic currency makes imports expensive, thereby increasing price of
items.
5.

Faulty Assumptions
PPP theory is based on faulty assumptions such as lack of transport cost, lack of trade
barriers such as custom duties and quotas etc. In reality international trade involves higher
transportation cost and is also affected by trade barriers.
6.

Does Not Consider Speculation In Foreign Exchange Market

Now-a-days there is lot of speculation in foreign exchange market, which affects the
exchange rate. PPP theory does not consider speculation in foreign exchange market.
7.

Limited Application To Large Countries

For large countries like India, China, U.S.A etc. the application of this theory is limited.
The PPP theory may have applicability to small countries where a large part of national income comes
form international trade.
8.

Neglects Capital Transfers

PPP theory takes into account only trade in merchandise. It excludes trade in services,
capital transfers and unilateral transfers. All such items create demand for and supply of foreign
exchange. By excluding such factors, the theory has limited relevance.
9.

Too Much Emphasis On Purchasing Power

PPP theory places too much emphasis on purchasing power as a determining factor of
rate of exchange. It ignores factors such as reciprocal demand of trading countries which can
influence the rate of exchange even with no change in price levels.
B. CONCLUSION:Though PPP theory is subject to various limitations, yet it has relevance in long-term.

Spot and Forward Exchange Rates and Real

Exchange Rate | International Trade
Spot and Forward Exchange Rates and Real Exchange Rate!
Transactions in the exchange market are carried out at what are termed as exchange rates.
The rate at which the currencies of two nations are exchanged for each other is called the rate
of exchange. For example, if 1 U.S. dollar is exchanged for Rs. 10 then foreign exchange rate
is 1 U.S. $ = Rs. 10.
In other words, the rate of exchange is nothing but the value or price of a countrys currency
expressed in terms of a foreign currency.
In the foreign exchange market, however, at any one point of time, there hardly exists a
unique rate of exchange. Rather there is a variety of exchange rates according to the credit
instruments employed for the transfer function.
Thus, there is a T.T. or cable rate, also called the spot rate, a sight rate in the case of foreign
currency bills, a usance rate or long rate which may be one months rate or 3 months rate and
also a forward exchange rate for future contracts. There is, thus, a cluster of rates in the
exchange market and not one rate between any two currencies.
1. Spot and Forward Exchange Rates:
Broadly speaking, we may distinguish between two types of exchange rates prevailing in the
foreign exchange market viz., spot rate of exchange and forward rate of exchange. Spot rate
of exchange and forward rate of exchange in terms of domestic money payable refers to the
price of foreign exchange in terms of domestic money payable for the immediate delivery of
a particular foreign currency.

It is, thus, a day-to-day rate. On the other hand, forward rate of exchange refers to the price at
which a transaction will be consummated at some specified time in the future. A forward
exchange market functions side by side with a spot exchange market.
The transactions of forward exchange market are known as forward exchange transactions,
which simply involve purchase or sale of a foreign currency for delivery at some time in the
future; the rates at which these transactions are consummated are, therefore, called forward
rates.
Forward exchange rate is determined at the time of sale but the payment is not made until the
exchange is delivered by the seller. Forward rates are usually quoted on the basis of a
discount or premium over or under the spot rate of exchange.
Currency Swap:
A sport of a currency when combined with a forward repurchase in a single transaction is
called currency swap. The swap rate is the difference between the spot and forward
exchange rates in the currency swap.
Usually, a forex market is dominated by the spot markets transactions swaps and forward
transactions.
Arbitrage:
Arbitrage is the act of simultaneously buying a currency in one market and selling in another
to make a profit by taking advantage of price or exchange rate differences in the two markets.
If the arbitrage operations are confined to two markets only, they will be known as twopoint arbitrage. If they extend to three or more markets, they are known as three-point
arbitrage or multipoint arbitrage.

2. Real Exchange Rate:

The real exchange rate is the nominal exchange rate adjusted for the relative price levels
variation. It may be measured as:
RER1 = NER1 (Pb1: O/Pa1: O)
Where,
RER = Real exchange rate (between the currencies of countries A and B).
NER = Nominal index for country B.
Pb = Price index for country A.
1 stands for current date
0 stands for base date
A higher degree of inflation rate in home country implies a lower real exchange rate and vice
versa. When the real exchange rate declines, it means a decrease in international
competitiveness of the country.
Variability in inflation rates leads to changes in real exchange rate