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Exchange RateDetermination
Unit 3Chapter 3
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Introduction
An Exchange rate is the price of one nationscurrency in terms of another currency, often
termed as the reference currency. E.g. the rupee/dollar exchange rate is just the
number of Rupees that one dollar will buy if a dollar will buy 100 Rupees then the exchange
rate could be expressed as Rs.100/$ and Rupees
will be the reference currency.. Similarly, the dollar/Rupees exchange rate is thenumber of dollars one Rupees will buy followingthe same example the exchange rate would be$0.01/Rs.
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When a currency becomes more
valuable relative to another currencyit is said to be appreciated. The priceof the foreign exchange has fallen(e.g. 1 USD buys Rs. 45 instead of
Rs. 39 earlier). When a currency becomes less
valuable relative to another currency,
it is said to be depreciated. The priceof the forei n exchan e has risen
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Exchange Rate Determination
It is determined by the equilibrating
interaction of buyers and sellers ofcurrencies in the FOREX market:demand and supply determine
exchange rates. Demandfor a currency for makingpayments for foreign trade and capitalflows.
Supply of a currency, during foreign
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Exchange Rate Equilibrium
An exchange rate represents the
price of a currency, which isdetermined by the demand for thatcurrency relative to the supply for that
currency.
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Exchange Rate Equilibrium
e
D
DS
S
Quantity of Rupees
Value
of
Rupees
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Factors Affecting Exchange
Rate
Relative Inflation
Rate:
U.S. inflation
U.S. demand for
Indian goods, andhence Rs.
Indian desire for
U.S. goods, and
Relative Interest
Rate:
U.S. interest rates
U.S. demand for
Indian bankdeposits, andhence demand forRs.
Indian desire for
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Factors contd..
Relative IncomeLevels:
U.S. income level U.S. demand for
Indian goods, andhence Rs.
No expected changefor the supply of Rs.
Political and EconomicRisk:
Investors prefer to holdlesser amounts of riskierassets, thus, low riskcurrenciesthoseassociated with more
politically andeconomically stablenationsare morehighly valued than highrisk currencies.
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PPP theory
Given by Gustav Cassel.
According to this theory, the pricelevels and the changes in the pricelevels in different countries determinethe exchange rates of these countrys
currencies. This theory is based on the principle
that the exchange rates between
various currencies reflect the
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PPP THEORY contd..
assumptions of Law of One Price are:
There is no restriction on the movementof goods between countries.
There is no transportation cost involved.
There is no transaction cost involved inthe buying and selling of goods.
There are no tariffs involved.
Example: US/French exchange rate: $1 =
.78Eur A jacket selling for $50 in New
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PPP THEORY contd..
According to this theory, the price of a commodityshould remain the same across the world. If notthen arbitrageurs would buy from cheaper marketand sell them in dearer market till price wouldbecome same in both countries/markets.
Another way to explain it is, that in equilibriumwhere domestic purchasing powers at the rate ofexchange are equivalent.
Therefore, the rate of exchange tends to rest atthat point which expresses equality between therespective purchasing powers of the twocurrencies. This point is called Purchasing PowerParity.
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PPP THEORY contd..
Reasons why PPP is not perfect:
PPP numbers can vary with the specificbasket of goods used, making it a roughestimate.
Preferences and choices can vary fromcountry to country. Goods then differ intheir contribution to welfare.
International competitiveness is mainly
affected by the exchange rate and not
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