UNIT 4

- DR. PARUL NAGI

Exchange Rates

► An exchange rate between two currencies is the rate at which one currency will
be exchanged for another.

► Exchange rates are determined in the foreign exchange market, which is open
to a wide range of buyers and sellers where currency trading is continuous.
► In the retail currency exchange market, a different buying rate and
selling rate will be quoted by money dealers.

► The foreign exchange rate is also regarded as the value of one

country’s currency in terms of another currency.

► The amount of one currency that a person or institution defines as

equivalent to another when either buying or selling it at any
particular moment.
► In finance, an exchange rate (also known as a foreign-exchange
rate, forex rate, or rate) between two currencies is the rate at which
one currency will be exchanged for another.

► It is also regarded as the value of one country’s currency in terms of

another currency.

► For example, an inter-bank exchange rate of 91 Japanese yen (JPY,

¥) to the United States dollar (USD, US$) means that ¥91 will be
exchanged for each US$1 or that US$1 will be exchanged for each
¥91.
How the Foreign Exchange Market
Works
► In the retail currency exchange market, a different buying rate and
selling rate will be quoted by money dealers.
► Most trades are to or from the local currency. The buying rate is the
rate at which money dealers will buy foreign currency, and the
selling rate is the rate at which they will sell the currency.
► The quoted rates will incorporate an allowance for a dealer’s
margin (or profit) in trading, or else the margin may be recovered in
the form of a commission or in some other way.
► Different rates may also be quoted for different kinds of exchanges,
such as for cash (usually notes only), a documentary form (such as
traveler’s checks), or electronic transfers (such as a credit card
purchase).

► There is generally a higher exchange rate on documentary

transactions (such as for traveler’s checks) due to the additional
time and cost of clearing the document, while cash is available for
resale immediately.
► Exchange rates are determined in the foreign exchange market,
which is open to a wide range of buyers and sellers where currency
trading is continuous.

► The spot exchange rate refers to the current exchange rate.

► The forward exchange rate refers to an exchange rate that is

quoted and traded today, but for delivery and payment on a
specific future date.
Finding an Equilibrium Exchange
Rate
► There are two methods to find the equilibrium exchange rate
between currencies;

► The balance of payment method

► The asset market model.

► The balance of payment model holds that foreign exchange rates are at an
equilibrium level if they produce a stable current account balance.
► The balance of payments model focuses largely on tradeable goods and
services, ignoring the increasing role of global capital flows.

► The asset market model of exchange rate determination states that the
exchange rate between two currencies represents the price that just balances
the relative supplies of, and demand for, assets denominated in those currencies.
This includes financial assets.
► Countries have a vested interest in the exchange rate of their
currency to their trading partner’s currency because it affects trade
flows.

► When the domestic currency has a high value, its exports are
expensive.

► This leads to a trade deficit, decreased production, and

unemployment.

► If the currency’s value is low, imports can be too expensive though

exports are expected to rise.
Purchasing Power Parity - The concept of
purchasing power parity is important for understanding the
two models of equilibrium exchange rates.

► A theory of long-term equilibrium exchange rates based on relative price levels of two
countries.

► Purchasing power parity is a way of determining the value of a product after adjusting
for price differences and the exchange rate.

► Indeed, it does not make sense to say that a book costs $20 in the US and £15 in
England: the comparison is not equivalent. If we know that the exchange rate is £2/$,
the book in England is selling for $30, so the book is actually more expensive in England

► If goods can be freely traded across borders with no transportation costs, the Law of
One Price posits that exchange rates will adjust until the value of the goods are the
same in both countries.
► Of course, not all products can be traded internationally (e.g. haircuts), and there are
transportation costs so the law does not always hold.
Balance of Payments Model

► The balance of payments model holds that foreign exchange rates are at an
equilibrium level if they produce a stable current account balance.
► A nation with a trade deficit will experience a reduction in its foreign exchange
reserves, which ultimately lowers, or depreciates, the value of its currency.
► If a currency is undervalued, its nation’s exports become more affordable in the
global market while making imports more expensive.
► After an intermediate period, imports will be forced down and exports will rise,
thus stabilizing the trade balance and bringing the currency towards equilibrium.
Asset Market Model

► Like purchasing power parity, the balance of payments model focuses largely on
tangible goods and services, ignoring the increasing role of global capital flows.

► In other words, money is not only chasing goods and services, but to a larger
extent, financial assets such as stocks and bonds.

► The flows from transactions involving financial assets go into the capital account
item of the balance of payments, thus balancing the deficit in the current
account.
► The increase in capital flows has given rise to the asset market model.

► The asset market model views currencies as an important element in finding the
equilibrium exchange rate.

► Asset prices are influenced mostly by people’s willingness to hold the existing
quantities of assets, which in turn depends on their expectations on the future
worth of the assets.
► The asset market model of exchange rate determination states that
the exchange rate between two currencies represents the price
that just balances the relative supplies of, and demand for, assets
denominated in those currencies.

► These assets are not limited to consumables, such as groceries or

cars.

► They include investments, such as shares of stock that is

denominated in the currency, and debt denominated in the
currency.
Exchange Rate Systems

► The three major types of exchange rate systems are

► The float,

► The fixed rate,

► and the pegged float.

Key Points

► A floating exchange rate or fluctuating exchange rate is a type of exchange

rate regime wherein a currency ‘s value is allowed to freely fluctuate according
to the foreign exchange market.

► A fixed exchange-rate system (also known as pegged exchange rate system) is a

currency system in which governments try to maintain their currency value
constant against a specific currency or good.

► Pegged floating currencies are pegged to some band or value, either fixed or
periodically adjusted. These are a hybrid of fixed and floating regimes.
Key Terms

► Exchange rate regime: The way in which an authority manages its currency in
relation to other currencies and the foreign exchange market.

► Floating exchange rate: A system where the value of currency in relation to

others is allowed to freely fluctuate subject to market forces.

► Fixed exchange rate: A system where a currency’s value is tied to the value of
another single currency, to a basket of other currencies, or to another measure
of value, such as gold.

► Pegged float exchange rate: A currency system that fixes an exchange rate
around a certain value, but still allows fluctuations, usually within certain values,
to occur.
► One of the key economic decisions a nation must make is how it will value its
currency in comparison to other currencies.
► An exchange rate regime is how a nation manages its currency in the foreign
exchange market.
► An exchange rate regime is closely related to that country’s monetary policy.
► There are three basic types of exchange regimes:
► floating exchange,
► fixed exchange,
► and pegged float exchange.
Foreign Exchange Regimes: The above map shows which countries have adopted which exchange rate
regime. Dark green is for free float, neon green is for managed float, blue is for currency peg, and red is for
countries that use another country’s currency.
The Floating Exchange Rate

► A floating exchange rate, or fluctuating exchange rate, is a type of exchange rate regime
wherein a currency’s value is allowed to fluctuate according to the foreign exchange market.

► A currency that uses a floating exchange rate is known as a floating currency.

► The dollar is an example of a floating currency.

► Many economists believe floating exchange rates are the best possible exchange rate regime
because these regimes automatically adjust to economic circumstances.

► These regimes enable a country to dampen the impact of shocks and foreign business cycles,
and to preempt the possibility of having a balance of payments crisis.

► However, they also engender unpredictability as the result of their dynamism.

The Fixed Exchange Rate

► A fixed exchange rate system, or pegged exchange rate system, is a

currency system in which governments try to maintain a currency value
that is constant against a specific currency or good.

► In a fixed exchange-rate system, a country’s government decides the

worth of its currency in terms of either a fixed weight of an asset, another
currency, or a basket of other currencies.

► The central bank of a country remains committed at all times to buy and
sell its currency at a fixed price.

► To ensure that a currency will maintain its “pegged” value, the country’s
central bank maintain reserves of foreign currencies and gold.
► They can sell these reserves in order to intervene in the foreign exchange market
to make up excess demand or take up excess supply of the country’s currency.

► The most famous fixed rate system is the gold standard, where a unit of currency
is pegged to a specific measure of gold.

► Regimes also peg to other currencies.

► These countries can either choose a single currency to peg to, or a “basket”
consisting of the currencies of the country’s major trading partners.
The Pegged Float Exchange Rate

► Pegged floating currencies are pegged to some band or value,

which is either fixed or periodically adjusted. These are a hybrid of
fixed and floating regimes.

► There are three types of pegged float regimes:

► Crawling bands
► Crawling pegs
► Pegged with horizontal bands
Crawling bands:

► The market value of a national currency is permitted to fluctuate

within a range specified by a band of fluctuation.

► This band is determined by international agreements or by unilateral

decision by a central bank.

► The bands are adjusted periodically by the country’s central bank.

► Generally the bands are adjusted in response to economic

circumstances and indicators.
Crawling pegs:

► A crawling peg is an exchange rate regime, usually seen as a part of fixed

exchange rate regimes, that allows gradual depreciation or appreciation in an
exchange rate.

► The system is a method to fully utilize the peg under the fixed exchange regimes,
as well as the flexibility under the floating exchange rate regime.

► The system is designed to peg at a certain value but, at the same time, to
“glide” in response to external market uncertainties.

► In dealing with external pressure to appreciate or depreciate the exchange rate

(such as interest rate differentials or changes in foreign exchange reserves), the
system can meet frequent but moderate exchange rate changes to ensure that
the economic dislocation is minimized.
Pegged with horizontal bands:

► This system is similar to crawling bands, but the currency is allowed to

fluctuate within a larger band of greater than one percent of the
currency’s value.
Fixed Exchange Rates

► A fixed exchange rate is a type of exchange rate regime where a

currency’s value is fixed to a measure of value, such as gold or
another currency.
Key Points

► A fixed exchange rate is usually used to stabilize the value of a

currency against the currency it is pegged to.
► A fixed exchange rate regime should be viewed as a tool in capital
control. As a result, a fixed exchange rate can be viewed as a
means to regulate flows from capital markets into and out of the
country’s capital account.
► Typically, a government maintains a fixed exchange rate by either
buying or selling its own currency on the open market.
► Another method of maintaining a fixed exchange rate is by simply
making it illegal to trade currency at any other rate.
Key Terms

► Fixed exchange rate: A system where a currency’s value is tied to

the value of another single currency, to a basket of other currencies,
or to another measure of value, such as gold.

► A fixed exchange rate, sometimes called a pegged exchange rate,

is a type of exchange rate regime where a currency’s value is fixed
against the value of another single currency, to a basket of other
currencies, or to another measure of value, such as gold.
Reasons for Fixed Exchange Rate
Regimes
► A fixed exchange rate is usually used to stabilize the value of a currency against the
currency it is pegged to.

► This makes trade and investments between the two countries easier and more
predictable and is especially useful for small economies in which external trade forms a
large part of their GDP.

► This belief that fixed rates lead to stability is only partly true, since speculative attacks
tend to target currencies with fixed exchange rate regimes, and in fact, the stability of
the economic system is maintained mainly through capital control.

► Capital controls are residency-based measures such as transaction taxes, other limits, or
outright prohibitions that a nation’s government can use to regulate flows from capital
markets into and out of the country’s capital account.

► A fixed exchange rate regime should be viewed as a tool in capital control.

How a Fixed Exchange Regime
Works
► Typically a government maintains a fixed exchange rate by either buying or
selling its own currency on the open market.

► This is one reason governments maintain reserves of foreign currencies.

► If the exchange rate drifts too far below the desired rate, the government buys its
own currency in the market using its reserves.

► This places greater demand on the market and pushes up the price of the
currency.

► If the exchange rate drifts too far above the desired rate, the government sells its
own currency, thus increasing its foreign reserves.
► Another, method of maintaining a fixed exchange rate is by simply making it
illegal to trade currency at any other rate.

► This method is rarely used because it is difficult to enforce and often leads to a
black market in foreign currency.

► Some countries, such as China in the 1990s, are highly successful at using this
method due to government monopolies over all money conversion.
► China used this method against the U.S. dollar.
► China is well-known for its fixed exchange rate.
► It was one of the few countries that could impose a fixed rate by making it illegal
to trade its currency at any other rate.
Managed Float

► Managed float regimes are where exchange rates fluctuate, but

central banks attempt to influence the exchange rates by buying
and selling currencies.

► Managed Float Regime: A system where exchange rates are

allowed fluctuate from day to day within a range before the central
bank will intervene to adjust it.
Key Points
► Generally the central bank will set a range which its currency ‘s value may freely float
between.

► If the currency drops below the range’s floor or grows beyond the range’s ceiling, the
central bank takes action to bring the currency’s value back within range.

► Management by the central bank generally takes the form of buying or selling large lots
of its currency in order to provide price support or resistance.

► A managed float regime is a hybrid of fixed and floating regimes.

► A managed float captures the benefits of floating regimes while allowing central banks
to intervene and minimize the risk of harmful effects due to radical currency fluctuations
that are a characteristic of floating regimes.
► Managed float regimes, otherwise known as dirty floats, are where
exchange rates fluctuate from day to day and central banks
attempt to influence their countries’ exchange rates by buying and
selling currencies.

► Almost all currencies are managed since central banks or

governments intervene to influence the value of their currencies.

► So when a country claims to have a floating currency, it most likely

exists as a managed float.
How a Managed Float Exchange
Rate Works
► Generally, the central bank will set a range which its currency’s
value may freely float between.
► If the currency drops below the range’s floor or grows beyond the
range’s ceiling, the central bank takes action to bring the currency’s
value back within range.

► India: India has a managed float exchange regime. The rupee is

allowed to fluctuate with the market within a set range before the
central bank will intervene.
► Management by the central bank generally takes the form of
buying or selling large lots of its currency in order to provide price
support or resistance.

► For example, if a currency is valued above its range, the central

bank will sell some of its currency it has in reserve.

► By putting more of its currency in circulation, the central bank will

decrease the currency’s value.
Why Do Countries Choose a
Managed Float
► Some economists believe that in most circumstances floating exchange rates are
preferable to fixed exchange rates.

► Floating exchange rates automatically adjust to economic circumstances and

allow a country to dampen the impact of shocks and foreign business cycles.

► This ultimately preempts the possibility of having a balance of payments crisis.

► A floating exchange rate also allows the country’s monetary policy to be freed
up to pursue other goals, such as stabilizing the country’s employment or prices.
► However, pure floating exchange rates pose some threats.

► A floating exchange rate is not as stable as a fixed exchange rate.

► If a currency floats, there could be rapid appreciation or depreciation of value.

► This could harm the country’s imports and exports. If the currency’s value
increases too drastically, the country’s exports could become too costly which
would harm the country’s employment rates.

► If the currency’s value decreases too drastically, the country may not be able to
afford crucial imports.
► This is why a managed float is so appealing.

► A country can obtain the benefits of a free floating system but still
has the option to intervene and minimize the risks associated with a
free floating currency.

► If a currency’s value increases or decreases too rapidly, the central

bank can intervene and minimize any harmful effects that might
result from the radical fluctuation.
Dark Green - IMF member states
Neon Green - IMF member states not accepting the obligations of Article VIII, Sections 2, 3, and 4[61]
12 Major Functions of International Monetary Fund
Function # 1. Fixation of Par Value of
Currencies in terms of Gold or Dollar:
► Every member country has to declare the par value of her currency
in terms of US Dollars or In gold.

► The main objective of IMF is to maintain stability in exchange rates of

the member countries.

► In fact, the IMF fixes the maximum or minimum limit of the par values
of various countries.
Function # 2. Alternation of Limit
within Par Value:
► There is over rigidity in the par values of the currencies of different
countries.
► If Fund finds that there is fundamental disequilibrium in the balance
of payments of a country, it can change the par values of its
currency,
► A country is allowed to alter its basic par value within well defined
limits i.e. upto 10 per cent after making her intention known to the
Fund.

► Under certain circumstances, the Fund itself can make

proportionate alterations in par values of all the member countries.
Function # 3. Loans of Foreign
Currency:
► The Fund realises that a stable exchange is very essential for the
proper growth and expansion of the free world trade.
► Therefore, it take-s steps to check the fluctuations in the par values
by eliminating the disequilibrium in the balance of payment of the
member countries.

► A member country can buy foreign currency from the Fund to tide
over her temporary balance of payments deficit.
► The Fund sells currencies to members against their subscriptions for
short period to enable them to remove the difficulties of the
balance of payment.
Function # 4. Drawing Rights:

► A member country during hardships of the balance of payments can buy

the required foreign currency from the Fund by offering more of its own
currency over and above its original subscription.
► The Fund provides both maximum and normal limits of financial assistance
for a short period.
► A member country can request for any currency under the credit line of
25 per cent of its quota in one year.

► This is known as gold tranche or reserve tranche drawing.

► But the full amount drawn under these drawings should not exceed by
200 per cent of the Fund’s holdings of a country’s currency quota.
► The member countries do not borrow more than 150 per cent of quota,
because any further borrowing in subject to increasing interference by
the Fund.
Function # 5. Stand by
Arrangements:

► Under the agreement of the Fund guarantee is given to provide a

specific sum of money for a given period of time to a member
country.

► Normally, the satisfaction as to the legitimacy and purpose of

drawing is considered before a standby is granted.

► Since the standby is a part of the quota, it forms a part of the total
drawing power.
Function # 6. Liquidity of Fund’s
Resources:

► If the borrowing countries are buying the currency of other

countries, the Fund may accommodate such currencies as are not
demanded.

► In fact, the Fund will not be able to act as a reserve Fund.

► Thus, it becomes necessary that the Fund should keep its resources
in a liquid form so that the borrowing country may repurchasing of
domestic currency.
There are certain rules to maintain
the liquidity of resources such as:

► (i) Any member country can buy the currency of any other member
country by depositing gold in the Fund.

► (ii) If the currency of a country with the Fund exceeds its quota, then
that country can purchase its own currency in exchange for gold.

► (iii) Every country, under special circumstances, can buy a part of its
own currency from the Fund in exchange for gold or other currency.
Function # 7. Currency in Short
Supply:
► It is possible that a country’s currency may be in short supply.

► Short supply of a currency in foreign exchange market indicates a

favourable balance of payment.

► If the Fund finds that a particular member country is having a surplus in its
balance of payment and its supply of currency is inadequate relative to
demand, the Fund may ask the surplus country to revalue its currency.

► On the contrary when the Fund declares a particular currency as scarce,

the member country revalues the currency, thus, raising costs and prices.
► This would increase its imports and the Fund can operate its operations
more effectively.
Function # 8. Position of Gold in
Fund’s Scheme:
► Under the Fund’s scheme, status was given to gold as every
member country has to deposit in gold the Fund upto 25 percent of
its quota or 10 per cent of its gold holdings.
► Under the agreement of the Fund, the par values of currencies of
members are expressed in terms of gold, SDR and the US Dollars.
► In Fund’s scheme, gold had been retained as a basis of
determination of the par values of member’s currencies.
► A member can deal with the Fund “only through its treasury, central
bank, stabilisation fund or other similar agency”.
► An alteration in par value is permitted only within limits. If the fund is
short of any particular currency, it can purchase the same for gold.
► The value of gold has been fixed by the Fund at 35 dollars per five
ounce.
► According to Prof. Williams, Fund’s Planning is akin to gold standard.
► But according to Lord Keynes, Under Fund’s planning, a system has been
created, by means of international agreement, that is far removed from
the old political gold standard system.

► It is so because:

► (a) It is not based on gold currency as was gold standard.

► (b) Under Fund’s planning, value of the currency is not fixed in terms of
gold forever.
► (c) Under gold standard, gold occupied the position of a master but
under Fund’s planning it is given the place of a servant. By virtue of the
amendments made in the regulations of the Fund, since 1976 gold has no
place in Fund’s planning.
Function # 9. A Central Bank’s
Bank:

► IMF may be described as a bank of Central Banks of different

countries.

► It collects the resources of the various Central Banks in the same

way in which a country’s Central Bank collects cash reserves of all
commercial banks in a country.
Function # 10. Facilities during the
Transition Period:
► The Fund gets all the exchange control removed so that the world
trade may flourish smoothly.
► During the transitional period, the Fund has empowered the
member countries to impose such restrictions on imports and foreign
exchanges according to its necessity.
► As the transitional period is over, member countries are supposed to
remove the restrictions imposed on international trade and foreign
exchanges.
► Therefore, the member countries can continue with their control to
the desirability of the Fund.
Function # 11. Training:

► The Fund also imparts training to the representatives of

member-countries.

► This training is imported to the senior officers of the central banks

and Finance Departments.
Function # 12. Facilities during
Emergency:

► Although IMF is opposed to any sort of controls either on foreign

exchange or foreign trade.

► Still member-countries have been given the right to resort to these

controls during emergency in the hope that they will lift it as early as
the situation warranted.