EXCHANGE RATE

DETERMINATION

Prepared By
Mariya Jasmine M Y

FOREIGN EXCHANGE
Popularly referred to as "FOREX"
The conversion of one country's
currency into that of another.
It is the minimum number of units of
one countries currency required to
purchase one unit of the other
countries currency.

WHY IT NEEDED???.....
Different countries have different
currencies with different values.
Example: India - Rupees
America -Dollar
China - Yuan
When trade takes place..
the persons of these countries
have to convert their currencies to other
countries currencies to make payments

 For this purpose the concept of

foreign exchange come into
operation.
Under mechanism of international
payments, the currency of a country
is converted in to the currency of
another country through FOREIGN
EXCHANGE MARKET.
The effect of globalization and
international trade
Increased import and export

FOREIGN EXCHANGE MARKET

Also called FOREX market.
It is the place were foreign moneys
were bought and sold.
It involves the buying of one currency
and selling of another currency
simultaneously.
Exchange rates are determined here.
Has no geographical boundaries..

FOREIGN EXCHANGE RATE

It is the rate at which one currency will
be exchanged for another in foreign
exchange.
It is also regarded as the value of one
countrys currency in terms of another
currency.
There are three basic types;
Fixed rate
Floating rate
Managed rate

FIXED EXCHANGE RATE

It is the system of following a fixed
rate for converting currencies.
In this system, the government (or the
central bank acting on its behalf)
intervenes in the currency market in
order to keep the exchange rate close
to a fixed target.
It does not allow major fluctuations
from the central rate.

Advantages
It provide the stability of exchange rate.
Fixed rates provide greater certainty for
exporters and importers.
Disadvantages
Too rigid to take care of major upheavals.
Need large reserves to defend the fixed
exchange rate.
May cause destabilizing speculations;
most currency crisis took place under a
fixed exchange system.

FLOATING/FLEXIBLE EXCHANGE
RATE
Under the flexible exchange rate system,
the rate of exchange is allowed to vary to
suit the economic policies of the
government.
Flexible exchange rates are exchange rates,
which fluctuate according to market forces.
The value of the currency is determined
solely by the forces of demand and supply
in the exchange market.(self correcting
mechanism)

Advantages
Automatic adjustmentfor countries
with a large balance of payments
deficit.
Flexibility in determining interest rates
Allow countries to maintain
independent
economic policies.
Permit a smooth adjustment to external
shocks.
Don't need to maintain large
international reserves.

Disadvantages
Flexible exchange rates are highly
unstable so that flows of foreign
trade and investment may be
discouraged.
They are inherently inflationary.

MANAGED EXCHANGE RATE

Managed exchange rate systems
permit the government to place some
influence on an exchange rate that
would otherwise be freely floating.
Managed means the exchange rate
system has attributes of both systems.
Through such official interventions it is
possible to manage both fixed and
floating exchange rates.

Simple Mechanism of Demand &

Supply
As stated earlier exchange rate is
determined by its the forces of supply and
demand.
Therefore, if for some reason people
increase their demand for a specific
currency, then the price will rise provided
that the supply remains stable.
On the contrary, if the supply is increased
the price will decline and it is provided that
the demand remains stable.

Purchasing Power Parity Theory

(PPP Theory)
Most widely accepted theory
According to PPP theory, when exchange
rates are of a fluctuating nature, the rate of
exchange between two currencies in the
long run will be fixed by their respective
purchasing powers in their own nations.
i.e the price of a good that is charged in one
country should be equal to the one charged
for the same good in another country, being
exchanged at the current rate.

 This rule is also known asthe law of

one price.
It is an economic theory that
estimatesthe amount of adjustment
neededon the exchange rate
between countries in orderfor the
exchange to be equivalent to each
currency'spurchasing power.

The Balance of Payment

Theory
The balance of payments approach is another
method that explains what the factors are that
determine the supply and demand curves of a
countrys currency.
As it is known from macroeconomics, the balance
of payments is a method of recording all the
international monetary transactions of a country
during a specific period of time.
The transactions recorded are divided into four
categories: the current account transactions, the
capital account transactions, financial account and
the central bank transaction.

CURRENT ACCOUNT
export and import of goods &services
CAPITAL ACCOUNT
Capital transfers
FINANCIAL TRANSFERS
Foreign direct investment
Portfolio investment
RESERVEBANK TRANSACTIONS

 According to the theory, a deficit in the balance of

payments leads to fall or depreciation in the rate of
exchange, while a surplus in the balance of
payments strengthens the foreign exchange
reserves, causing an appreciation in the price of
home currency in terms of foreign currency. A deficit
balance of payments of a country implies that
demand for foreign exchange is exceeding its supply.
As a result, the price of foreign money in terms of
domestic currency must rise, i.e., the exchange rate
of domestic currency must fall. On the other hand, a
surplus in the balance of payments of the country
implies a greater demand for home currency in a
foreign country than the available supply. As a result,
the price of home currency in terms of foreign money
rises, i.e., the rate of exchange improves.

DETERMINANTS OF FOREIGN EXCHANGE RATE

1. Interest Rate
Whenever there is an increase interest rates in
domestic market there will be increase
investment funds causing a decrease in demand
for foreign currency and an increase in supply of
foreign currency.

2. Inflation Rate
when inflation increases there will be less
demand for local goods (decreased supply of
foreign currency) and more demand for foreign
goods (increased demand for foreign currency).

3. Government budget deficit or

surplus
The market usually react negatively to
widening govt. budget deficits and
positively to narrowing budget deficits.
This will result in change in the value of
countries currency.

4. Political conditions
Internal, regional and international
political conditions and events can have a
profound effect on currency market