. Foreign Exchange Rate Determination

TERMINOLOGIES Foreign Exchange rate

• Foreign exchange rate is the rate at which one currency is exchanged for other.

• It is the price of one currency in term of other• The exchange rate between dollar and pound refers to

numbers of dollars required to purchased one pound• For example if $2.50=£1• It means that value of £0.40 pound =$1

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Foreign Exchange:

• The exchange rate of $2.50=£1 or £0.40=$1 will be eliminated in world market by arbitrage

• What is arbitrage: • it refers to the purchase of foreign currency in one

market where its price is low and sell it in another market where it price is high

• The effect of arbitrage is to remove differences in exchange rate , so that single exchange rate prevail in world market

• If exchange rate is $2.48 in London exchange market and $2.50 in new York exchange market

Foreign Exchange:

• Arbitrageurs will buy pounds in London and sell them in new York for earning profit

• As a result the price of ponds in term of dollars in London market rises and falls in the new York market

• This process will end the arbitrage practice

Determination of equilibrium exchange rate

• The exchange rate in a free market is determined by the demand and supply of foreign exchange

• Equilibrium exchange rate is a rate at which demand for foreign exchange is equal to supply of foreign exchange

• It is the rate which clears the foreign exchange market• Two method for clearing the market• A) Demand and supply of dollars with price of dollars in

pounds• B) Demand and supply of pounds with price of pounds in

dollars…………both method yields same result

Determination of equilibrium exchange rate (cont…)

• 1) Demand for foreign exchange • The demand for foreign exchange (pounds) is a derived from

demand from pounds

• It arises from import of British goods and services into U.S and from capital movements from the U.S to Britain

• Demand for pounds implies supply of dollars

• When U.S businessmen buy British goods and services and make capital transfers to Britain they create demand for British pounds in exchange for U.S dollars


• Demand curve for pounds DD is sloping downward from left to right

• It means that lower the exchange rate on pounds( pounds became cheaper) (dollars price of pound) the larger will be demand for pounds in foreign market

• This means that British exports of goods and services cheaper in term of dollars

• The opposite happens if exchange rate on pounds (dollars price of pound) is higher

• It will make British goods and services dearer


• Supply of foreign exchange• Supply of foreign exchange in our case is the supply of pounds• It arises from U.S exports of goods and services to Britain and

capital movement from U.S to Britain• British holders of pounds wish to make payment in $, thus

supply of pounds in market will increase • Supply curve for pounds SS is an upward sloping curve• The relation between exchange rate on pounds (dollar price

of pounds) and supply of pounds is positive • If exchange rate on pounds increases U.S goods and services

become cheaper in Britain ,they would purchase more and as a result supply of pounds in a market increase


S

S D

pounds

Exc

hang

e ra

teDollar price of pounds

R

Q

R2

R1

0


• Given the demand and supply curve for foreign exchange, the equilibrium exchange rate is determined where demand for pounds intersects supply of pounds

• Equilibrium exchange rate is “R” and OQ shows equilibrium demand and supply of foreign exchange rate

• If exchange rate is higher than equilibrium exchange rate it means that supply of pounds is greater than demand for pounds

• The price of pounds will fall and ultimately equilibrium exchange rate will reach and economy will come back to equilibrium point i.e point “E”


• An exchange rate lower than equilibrium rate mean demand for foreign exchange rate is greater than supply of foreign exchange rate

• This leads to increase the price of pounds in foreign exchange market

• so exchange rate will tends to increase and equilibrium rate will re-established in market

• Economy come back to equilibrium point i.e. point “E”

Theories of Foreign Exchange

1:The Mint Parity theory2: The purchasing Power Parity Theory3: The Balance of Payments theory

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The Mint Parity Theory This theory is associated with the working of the International Gold

Standard. (gold standard operated between 1880—1914 )Under this system, the currency in use was made of gold or

convertible into gold at a fix rate. The value of one currency unit was defined in terms of certain weight of gold, that is, how many grains of gold is equal to one dollar or one pound etc.

The central bank of a country was ready to buy and sell gold at specific price

The rate at which the standard currency of a country was convertible into gold was called the Mint Price of gold.

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Explanation of the Theory The official British price of gold in British was £ 6 per once and

in the US price of gold $36 per once, so they were the mint price of gold in respective countries. The exchange rate between $ and £ would be fixed at $36/£6=

$6 This rate was called the mint parity or mint par of exchange

because it was based on the mint price of gold Thus under the gold standard, the normal rate of exchange was

equal to the ratio of their mint par values R= $/ £

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Explanation of Mint Parity Theory (cont…)

• But the actual exchange rate could vary above and below the mint parity due to cost of shipping the gold between countries

• Suppose U.S has deficit in its BOP with Britain• This deficit in BOP will be paid by U.S importer in term of gold

• Suppose the shipping cost of gold from U.S to U.K is 3 cents

• So U.S importer will have to pay $6.03 for one pound• This is actual exchange rate

Assumption of the Mint parity Theory

1. It buys and sells gold in any amount at that price.2. Supply of money consists of gold or paper currency which is

backed by gold.3. There is movement of gold between countries4. Capital is moveable within countries.5. Price directly varies with money supply

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Criticisms on Mint Parity Theory1. The international gold standard does not exist now ever

since after 19302. The theory is based on the free buying and selling of gold

and its movement between countries , while Govt. do not allow such sales or purchases and movement

3. The theory is fails to explain the determination of exchange rates as most countries are on inconvertible paper currencies

conclusion The mint parity theory has been discarded since the gold

standard broke down now. There are neither free movements of gold nor gold parities

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The Purchasing Power Parity Theory (PPP)

The PPP theory was developed by Swedish economists Gustav Cassel in 1920 to determine the exchange rate between countries on inconvertible paper currencies.

This theory states that, the rate of exchange between two

countries is determined by purchasing power in two different countries

PPP have two versions: 1. The absolute purchasing power parity theory 2. The relative purchasing power parity theory

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PPP Theory

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1) Absolute Purchasing power parity

The absolute version states that the

exchange rates between two countries is equal to the ratio of the price level in the two countries. The formula is,

R AB = PA /PB

where RAB is the exchange rate between

two countries A and B and PA and PB refers to general price level in two countries

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Absolute Purchasing power parity (cont..)

For example if price of one bushel of wheat is $1 in U.S and £1 in U.K then exchange rate between $ and £ is equal to 1

According to the law of one price, a given commodity should have

same price So purchasing power of two currencies is at parity in both

countries If the price of one bushel of wheat in term of $ were $0.50 in U.S

and £1.50 in U.K …firm would purchase wheat in U.S and resell it in U.K at profit

Absolute Purchasing power parity (cont..)

This commodity arbitrage would cause the price of wheat to fall in U.K and rise in U.S until the prices were equal to $1per bushel in both economies

Criticisms This version is not use because it ignore the

transportation cost and other factors.

2) The Second Version ( Relative purchasing parity)

According to this version the change in the exchange rate over a specific period of time should be proportional to the relative change in price level in the two nations over the same period of time

The formula used for determination of exchange rate is R1 =P1a/P0 . R0

where R1 shows exchange rate in period 1, and R0 shows

exchange rate in base period for example if general price level does not change in foreign

nation from the base period to period 1Where as general price level in the home nation increase by 50%

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P1b/P0

The Second Version ( Relative purchasing parity)

So according to PPP theory the exchange rate (price of a unit of foreign currency in term of domestic currency) should be 50% higher in period 1 as compared to the base period (home currency depreciated by 50%)

This theory can be explain with the help of other example. Suppose India and England are on inconvertible paper standard

and by spending Rs.60, the bundle of goods can be purchased in India as can be bought by spending £ 1 in England. Thus, according to PPP, the rate of exchange will be Rs. 60= £ 1

Suppose domestic price index increase by 300 and foreign price index rises to 200 the new exchange rate will be Rs 60 =£1.5

Explanation (PPP) The exchange rate would be a proper reflection of

the purchasing power in each country if the relative values bought the same amount of goods in each country.

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BOP theory for Determination of exchange rate

According to this theory ,exchange rate of a currency is depends one on its BOP position

A favorable BOP raise the exchange rate And unfavorable BOP reduces the exchange rate Thus according to this theory exchange rate is determined by

the demand and supply of foreign exchange Demand for foreign exchange arises from the debit side of the

balance sheet Supply of foreign exchange arises from credit side of balance

sheet

BOP theory for Determination of exchange rate (Cont…)

• When BOP is unfavorable it means that demand for foreign currency is more than its supply

• It means that external value of domestic currency in relation to foreign currency fall

• Consequently exchange rate to fall…..how ?• Suppose RS 60=$1 , external value of domestic currency

is .017• Due to unfavorable BOP Rs90=$1 so external value of

domestic currency is ……… .011• On other hand if BOP is favorable it means that supply of

foreign is greater than demand• It means that external value of domestic currency in relation

to foreign currency rise


• Consequently exchange rate to rise• Suppose RS 60=$1 , so external value of domestic currency is

.017• Due to favorable BOP Rs 40=$1 so external value of domestic

currency is ……… .025• In conclusion, in foreign exchange determination BOP is

important

•


S

S D

Exc

hang

e ra

te price of $ in Rupee

R

Q

R2

R1

0Dollars

. Foreign Exchange Rate Determination

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