Exchange Rate Determination & Theories for Equilibrium Rate of Exchange

Foreign Exchange Market International Financial Management

By: Ravi Khatri

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 SUPPLY.

Exchange Rate Equilibrium

Forces of Demand and Supply
Demand for foreign currency negatively

related to the price of foreign currency Supply of foreign currency positively related to the price of foreign currency Forces of demand and supply together determine the exchange rate

Demand for Foreign Currency

Price for Foreign Currency

D $2.00 $1.50 D
50m 75 m Units of Foreign Currency ()

Supply of Foreign Currency

Price for Foreign Currency

$2.00

$1.50 S
50 m 75 m Units of Foreign Currency ()

Equilibrium Exchange Rate

Exchange Rate

$1.6775

D
Units of Foreign Currency()

Equilibrium Rate of Exchange

The equilibrium 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 equilibrium 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 Equilibrium Rate of Exchange

I. Mint Parity Theory

II. Purchasing Power Theory III. Balance of Payment Theory IV. Interest Rate Parity Theory

I. Mint Parity Theory

When 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.

e.g., before World War-I, England and America were simultaneously on a full-fledged Gold Standard.
Gold Sovereign(Pound) = 113.0016 grains of Gold Gold Dollar = 23.2200 grains of Gold

/$ = 113.0016/23.2200 1 = $4.8665

Assumptions of the Theory

1) The price of gold is fixed by a country in terms of its

currency. 2) It buys and sells gold in any amount at that price. 3) Its supply of money consists of gold or paper currency which is backed by gold. 4) Its price level varies directly with its money supply. 5) There is movement of gold between countries. 6) Capital is mobile within countries. 7) The adjustment 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) Free 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 Fiat currency system. iv) This theory assumes flexibility of internal prices, but modern governments follow independent domestic price policy unrelated to fluctuations in exchange rate.

II. Purchasing Power Parity (PPP) Theory

Cassel suggested purchasing power parity as the appropriate level at which to set the exchange rate.
Principle 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).
It follows that the main factor determining the exchange rate is the relative purchasing power of the two currencies. Thus, the equilibrium rate of exchange should be such that the exchange of currencies would involve the exchange of equal amounts of purchasing power. Hence, it is the parity (equality)of the purchasing power of the currencies which determined the exchange rate.

Two Versions:
1. Absolute or Positive Version: A bundle of Goods = $10 A bundle of Goods = Rs. 400 $10=Rs400 $1=Rs.40 Criticism: a) Firstly 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) Secondly, the goods produced and demanded in two different countries are not of the same kind and quality, therefore the equalization of goods prices - internal purchasing power of two currencies cannot be envisaged.
c) As a matter of fact, the relative price structure between two countries cannot be identical on account of differences in qualities and characteristics of goods and services, differences in demand patterns, differences in technology, influence of transport costs , differ-ring tariff policies

2. Comparative Version:(price index in current period / price index in the base period) in the home country (price index in current period/ price index in the base period) in the foreign country

Criticisms of the Purchasing Power Parity Theory

i) It is Difficult to Measure Accurately the Purchasing of the

Currency Units of the Two Countries ii) It Neglects the Cost of Transportation iii) It Neglects the Price of Goods iv) It Does Not Study Other Elements Which Influence the Balance of Payments v) The changes in the Rate of Exchange Influence the Price Level vi) This theory is contrary to General Experience vii) This Theory does not explain the Demand of Foreign Currencies viii) This theory assumes a Given Rate of Exchange ix) This Theory is Based on a Wrong Conception of Elasticity of Demand x) The theory offers only a Long Term Explanation of the Rate 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. It 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. Balance of Payment Theory

Also known as Demand and Supply theory of Exchange Rate.

Demand Value of Currency Demand Value of Currency

The extent of the demand or the supply of a countrys currency in the foreign exchange market depends on the balance of payment position. Equilibrium BOP: Supply=Demand
Deficit BOP: Supply>Demand, External Value of Currency Surplus BOP: Supply<Demand, External Value of Currency

Merits
It provides an explanation of the determination of demand and supply schedules of a currency in the foreign exchange market. For 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 just 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 adjusted through various policy measures.

The theory is able to accommodate unilateral capital movements irrespective of their nature, duration and magnitude. Thus, it explicitly recognizes the fact that rate of exchange is subject to diverse pressures, including for example , war preparations, servicing of outstanding foreign debts, speculative flights of capital and so on.

Demerits
1. It 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.
2. The theory does not explain what determines the internal value of a currency. For this we have to resort to purchasing power parity theory. 3. It unrealistically assumes the balance of payments at a fixed quantity. 4. According to the theory, there is no causal connection between the rate of exchange and the internal price level. But, in fact , there should be such connection , as the balance of payments position may be influenced by the price cost structure of the country. 5. The theory is indeterminate at a time. It states that the balance of payments determines the rate of exchange. However, the balance of payments itself is a function of the rate of exchange. Thus, there is a tautology, what determines what, is not clear.

IV. Interest Rate Parity Theory

The IRP theory states that equilibrium is achieved when the forward rate differential is approximately equal to the interest rate differential. F = S + S[(1+Rh /1+Rf ) -1] e.g., RINDIA = 10% & RUS = 7% Spot Rate = INR 40/ USD 1
Then, 90 days Forward Rate = 40 + 1/4[(1.10/1.07) - 1]

F = Rs. 40.28/USD

Causes of Changes / Fluctuations In Exchange Rates

Foreign Exchange Market International Financial Management

By: Binoy Babu

Causes of Changes / Fluctuations In Exchange Rates

1. Trade Movements
2. Capital Movements 3. Stock Exchange Operation 4. Speculative Transactions 5. Banking Operations

6. Monetary Policy
7. Political Conditions

8. Inflation Rates
9. Interest Rates 10. Economic Growth 11. Political & Economic Risk 12. Changes in Future Expectations

13. Government Intervention

Foreign Exchange Rate Policy

I. Fixed Exchange Rate

Arguments for Fixed Exchange Rate:

1. 2. 3. 4.

5.
6. 7.

8.

Risk of Uncertainty Monetary and Fiscal Discipline Convenience Need Source of Economic Benefit Historical Relevance Prevents Capital Outflow Promotes Capital Movements

Arguments against Fixed Exchange Rate: 1. Domestic Stability 2. Curbing Comparative Market Forces 3. Choice of Rate 4. Transient Nature 5. Economic Cost of Control 6. Retarding Trade and Capital Flows

II. Flexible Exchange Rate

Arguments for Flexible Exchange Rate: 1. Shock Absorption 2. Effectiveness of Monetary and Fiscal Policy 3. Balance of Payment Adjustment 4. Foreign Exchange Reserves

Arguments against Flexible Exchange Rate:

1. Risk to the Economy 2. Business Risk 3. Money Supply