The foreign Exchanges and foreign excahnge control session 21-22 | Fixed Exchange Rate System | Exchange Rate

THE FOREIGN EXCHANGES

MEANING OF FOREIGN EXCHANGES The Foreign Exchange is used in two senses 1) Wide sense : According to some economists, the term Foreign Exchange refers to that entire operation by which two countries clear of f their indebtedness. It includes i) all those institutions which facilitate foreign payments . Ii) all those methods and mechanisms which are made use of for making international payments and iii) the rate at which the currency of one country is converted into the currency of another country. 2) Narrow sense : some economists have used the term Foreign Exchange in a narrow sense. According to them, foreign exchange refers to the rate of exchange or the rate at which the currency the sale and purchase of foreign currencies. According to still some economists, the term Foreign Exchange refers to the rate of exchange or the rate at which the currency of one country is converted into the currency of another country.

PROBLEM OF FOREIGN EXCHANGE

Every country has its own currency. For international payments the currency of one country has to be converted into the currency of another country, because every country wants the payments for its exports to be made in terms of its own currency.

METHODS OF FOREIGN PAYMENTS A country can make payments to another country in three ways: 1. This method is highly defective. But this system is also defective because the cost of transporting gold from country to another is quite prohibitive these days. but in terms of commodities. 3. Export of gold . The payment for foreign goods can also be made in terms of gold. . 2. According to this method. the trader of a country makes the payment for the imported goods through the medium of foreign exchange bills. Payment through Foreign Exchange Bills. Export of commodities : payment are made not in terms of currency or gold. The foreign payments these days mostly made through foreign exchange bills.

making payments through bank drafts is a time consuming process. then the importer makes the payment through telegraphic transfer. Taking exchange bill in the bank to get his payment . 3. like bankers drafts are issued by the Exchange Bank. The exchange bill is generally for a period of three months . Telegraphic transfer. An importer can make the payment for the imported goods by sending the banker s draft to the exporter of the country. The third method of making international payments is telegraphic transfer. as one cannot wait for three months for the receipt of payments. Bankers Draft : this is the second method of making international payments. The banker s draft is always drawn in terms of foreign currency. The importer can purchase the telegraphic ttransfers by depositing national currency with the Exchange Bank . If the foreign exporter has to be paid immediately. 2. Generally. 1. Bill of Exchange : Most of the international payments these days are made through the medium of exchange bills.The foreign exchange bills are generally of three types. Telegraphic Transfer.

The supply of foreign currency comes from those people who have exported their goods. . the rate of exchange ) at any time is determined by the demand and supply of that currency. They need foreign exchange because the exporter of the foreign country insists upon receiving the payment in his national currency.DEMAND AND SUPPLY OF FOREIGN CURRENCY The demand for foreign currency arises from those traders who have to make payments for imported goods to the foreign in exporter. The demand for foreign currency arises from those individuals who imports goods and services or wish to make investment in foreign countries. Thus the price of any foreign currency ( or .

Just as the price of a commodity is determined by the demand and supply. in the same manner . What this implies is that one Indian rupee can fetch 0. the price of foreign currency is also determined by its demand and supply. Any changes taking place in the demand and supply of foreign currency will certainly affect its price in foreign exchange market . In fact the rate of exchange keeps on changing in the foreign exchange market on account of the changes in the demand and supply of foreign currency. The rate of exchange thus. indicates the exchange ratio between the currencies of the two countries. Let us suppose that one Indian Rupee is equal to 0.0476 Pound sterling.0476 Pound sterling in the exchange market.EQUILIBRIUM RATE OF EXCHANGE The rate of exchange refers to the rate at which the currency of one country can be converted into the currency of another country. .

. But the rate of exchange between two countries on inconvertible paper currency standard can rise above or fall below the purchasing power parity.levels of the two countries. But the purchasing power parity between two countries on inconvertible paper currency standard instead of being constant. 4. 3. But the rate of exchange between two countries on inconvertible paper standard is determined by the purchasing power of their currencies in terms of goods and services.DETERMINATION OF EXCHANGE RATE UNDER GOLD STANDARD AND PAPER CURRENCY STANDARD A COMPARISION The following differences are found in the determination of exchange rate between two countries on the gold standard and two countries on inconvertible paper currency standard: 1. The rate of exchange between two countries on the gold is determined by mint par of exchange. The changes in the exchange rate of exchange between two countires on the gold standard remain confined to the gold points. But the rate of exchange between two countries on inconvertible paper currency standard is determined by the purchasing power parity of the currencies . is subject to changes from time to time as a result of the exchanges in the price. The mint par of exchange between two countries on the gold standard remains constant. The rate of exchange between two countries on the gold standard is determined by the purchasing powers of their currencies in terms of gold. 2.

When one country is on the gold standard while other is on the silver standard .PARITY OF EXCHANGE The rate of exchange is determined by the demand and supply of foreign exchange. . 2. 3. When the demand for foreign exchange is exactly equal to its supply than the rate of exchange is said to be at par or there is said to be equal parity of exchange . This parity of exchange itself is determined in different ways under different conditions . When one country is on gold standard while the other is on inconvertible paper currency standard . But in actual life. When both the countries are either on the gold or on the silver standard . the demand for foreign exchange is seldom equal to its supply. This limits are different under different conditions. When both the countries are on inconvertible paper currency standard. Four problems under the determination of the rate of exchange under four different situations. 4. Now the question arise as to what extent can the actual rate of exchange rise above or fall below the parity of exchange? There certain limits within which the actual rate of exchange fluctuates round the parity of exchange. 1.

PURCHASING POWER PARITY THEORY This theory was propounded by the well known Swedish economist. . In other words . Gustav Cassel after the First World War. the theory was first mooted by John Wheatley in 1802. According to some economists. the rate of exchange tends to rest at that point which expresses equality between the respective purchasing powers of the two currencies . Prof. This point is called the purchasing power. According to Gustav Cassel the rate of exchange between two currencies must stand essentially on the quotient of the internal purchasing powers of these currencies .

It does not study other elements which influence the balance of payments 5. B) The price-index number s include the prices of even those commodities which are not internationally traded . It neglects the cost of transportation. 10. The changes in the rate of exchange influence the price level. A) The index number are connected with the past price.CRITICISMS OF THE PURCHASING POWER PARITY THEORY 1. This theory does not explain the demand for foreign currencies. The theory offers a long term explanation of the rate of exchange but not considers the short-term rate of exchange . 3. It neglects the quality of goods 4. This is contrary to general experience. 2. the purchasing power parity of their currencies cannot be ignored or overlooked in any manner. 8. 6. This theory assumes a given rate of exchange. 9. It concludes that the purchasing power parity theory is useful theory. While fixing a rate of exchange between the two countries . This theory is based on a wrong conception of elasticity of demand. C) The third defect of these index numbers is that they do not include the same commodities in the both countries . . They do not deal with the present prices in the two countries . It is difficult to measure accurately the purchasing powers of the currency units of the two countries. 7. In the long period the rate of exchange has a tendency to coincide with the purchasing power parity of the currencies of the two countries .

the price of foreign currency in terms of the domestic currency. 4. 2. This theory points out the disequilibrium in the balance of payments of a country can be corrected by making appropriate adjustments in the rate of exchange. This theory brings the determination of the rate of foreign exchange within overall framework of the general equilibrium. besides exports and imports which influence the supply and demand for foreign exchange . This theory points out that there are several important forces. .THE BALANCE OF PAYMENTS THEORY OF EXCHANGE RATE This theory is also known as the general equilibrium theory of exchange rate. This theory at present is supposed to be the most satisfactory theory of exchange rate. The rate of exchange is only a price. Most satisfactory theory 1. According to this theory . the rate of exchange between the two countries is determined by the supply of and demand for foreign exchange in the exchange market . This theory is in conformity with general theory of value. 3.

. 2. Currency conditions The currency conditions also deeply influences the rate of exchange of a country. Changes in the demand and supply of foreign currencies. shares and securities.. The following are the causes of instability in the rate of exchange during short period. 1. it keeps on fluctuating from time to time both under gold standard as well as under the inconvertible paper currency standard. b) loan transactions 2. i) bank rate ii) Issuing credit Instruments iii) Arbitrage Operations for speculative gains in different stock exchange 3. Banking influences .. . Likewise. These fluctuations in the rate of exchange create a good deal of uncertainty which can have harmful repercussions on the flow of foreign trade. the rate of exchange between two countries on inconvertible paper currency standard may either below or above purchasing power parity.FLUCTUATIONS IN THE RATE OF EXCHANGE As pointed above . the rate of exchange between two countries is seldom constant. On contrary . The rate of exchange between two countries on the gold standard either above or below mint parity. Trade conditions i) stock exchange Influences a) sale and purchase of stocks .

4. The stability in the rate of exchange can also be achieved to some extent by making appropriate changes in the bank rate of the country. The stability of the rate of exchange depends upon the equilibrium in the balance of payments. i) Policy of protection ii) Exchange control iii) financial Policy of the government iv) Peace and security in the country. No definite limit for fluctuation of rate of exchange of the foreign currency. How check fluctuations in the rate of exchange ? The fluctuating rate of exchange is influenced by a large variety of factors. 2) Limits of Fluctuations under Inconvertible paper currency standard : it is based on the purchasing power parity.i) Inflation : the onset of the inflation in a country results in the repatriation of foreign capital from country ii) Deflation : The onset of deflation results in the inflow of foreign capital into the country . Political conditions . To make financial gains . . Thus. Limits of fluctuations in the exchange rate 1) Limits of Fluctuations under gold Standard : The rate of exchange between two countries on the gold standard is governed by the gold points. it becomes important to check the violent fluctuating rate of exchange.

5.STABLE VS. 4. 2. A stable rate of exchange is also necessary for small country in whose economy foreign trade plays a significant role such as Britain and Denmark. by creating uncertainty in the minds of the lenders and borrowers. A stable rate of exchanges enables the importers and exporters to know in advance how much they are going to gain from the trade or to pay for it. A fluctuating rate of exchange . A developing country should invariably opt for a stable rate of exchange to achieve its planned economic development. 1. While fluctuating rate of exchange will retard the development of the country by impeding the inflow of capital from abroad. 3. A stable rate of exchange also appears to be indispensible for the smooth functioning of the currencies blocs. by creating uncertainty will discourage the development of the foreign trade of the country . A country should adopt a policy of stable rate of exchange in order to develop and promote foreign trade. FLUCTUATING RATE OF EXCHANGE IT IS CONTROVERSIAL WHETHER THE SHOULD HAVE STABLE OR FLUCTUATING EXCAHNGE RATE ? Arguments for stable Exchange rates. . A stable rate of exchange is also essential for sustained and uninterrupted international lending on a large scale . A fluctuating rate of exchange . discourages international capital movements.

It is wrong to say that a fluctuating rate of exchange hampers the development of foreign trade of a country. 4. A fluctuating rate of exchange protects the domestic economy of a country from the shocks generated by disturbances originating abroad . A system of fluctuating foreign exchange rates enables a country to find out its natural rate of exchange in course of time. A system of stable exchange rate does not reflect the true cost price relationship between the currencies of the countries. The technique of forward exchange transactions protects the importers and exporters from financial losses consequent upon fluctuating exchange rates. 2. 3. A system of fluctuating exchange rates automatically brings about equilibrium in the balance of payments of a country. Arguments for fluctuating Exchange rates 1. A system of stable exchange rate places the burden of adjustment in the balance of payments of a country on domestic incomes and prices. . A fluctuating rate of exchange is no hindrance in the smooth functioning of the currency blocs. 2. 5.Arguments against Stable Exchange rates 1.

This flexibility has been provided by the International monetary fund ( IMF). 2. . Hindering in long term investments by creating uncertainty . Conclusion We conclude that neither the constantly fluctuating nor a rigidly stable rate of exchange is in the interest of country. It is essential to bring the rate of exchange to enable country to reach its natural rate of exchange. The best solution would be to devise an arrangement which allows a country to change its rate of exchange within certain well defined limits in response to changes in the international economy.Arguments against fluctuating exchange rates 1. Speculative capital movements engendered by a system of fluctuating rates of exchange may. 4. 3. 5. because such the fluctuating exchange rate will have serious repercussions on the entire structure of that country by changing the prices of imported and exported goods from time to time . A system of freely fluctuating exchange rate induces unnecessary and unwarranted international capital movements. create the problem of an extremely high liquidity preference amongst the people. No country will can allow its rate of exchange to drift from day to day in response to international events. in turn. Both of them are harmful.

To get over the difficulties of Peg system an alternative proposal known as Crawling Peg system was mooted by James Meade. the exchange rate of the country was allowed to deviate from the par value of its currency within the margin of 1% on either side of the exchange parity. It plays significant role in international trade.25% to more wider range up to 4. . securities commodities. According to this system. Though the term arbitrage is wide one. This system allows a wider margin for the rate of exchange to fluctuate either side of the par value of the currency of the member country. Arbitrage : this refers to the act of simultaneously buying foreign exchange. it is generally used in relation to foreign exchange transaction s. means the sale and purchase of foreign exchange in the future market. Forward exchange trading thus. It may crawl up to 2. The forward exchange rates are determined by the demand for and supply of foreign currency . In one market and selling them in another market at a higher price.A DJUSTABLE PEG AND CRAWLING PEG SYSTEMS OF EXCAHNGE RATES The adjustable peg system of exchange rate was provided in the constitution of the IMF.5% Forward Exchange : after First world war adoption of system of inconvertible paper currency to avoid violent fluctuations. etc.

‡ System (methods / mechanisms/ principles) whereby different nations clear off their international obligations / payments / indebtedness ‡ Rate of exchange at which currency of a country is converted into the currency of another country Methods of Foreign Payments ‡ Export of Commodities ‡ Export of Gold ‡ Payments through Foreign Exchange Bills ‡Bills of Exchange ‡Banker s Draft ‡Telegraphic/Electronic (swift code) Transfer . Convertibility of Indian Rupee) Foreign Exchange (FE) ‡ All those institutions which facilitate foreign payments.Foreign Exchange & Exchange Control (EC).

Equilibrium Rate of Exchange  That rate of exchange at which currency of one country can be converted into the currency of another country.  Shows exchange ratio Eg: Exchange Rate of Rupee 1 U.S. $ = 48.0205 US$  Determined like price of commodities  It keeps changing on a/c of Dd. & SS of foreign currency . Supply comes from Exporter of goods & services & those who have imported capital from abroad + foreign investments.60 or 1 Rupee = .Demand & SS of Foreign Currency/Equilibrium Rate of Exchange Demand comes from Importer of goods & services and those who wish to invest in foreign countries.

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$) Single Rate or Multiple Rates Single Rate One r. When expressed in Foreign Currency  Higher rate is favorable (1 Rupee = .S.0266 U.S. $ = 48 Rs.*Favorable & Unfavorable R.S. exchange for all types of transaction Multiple Rate Many exchange rates  one rate for exports  one rate for imports  one rate for tourists  cash / Traveler s cheques / electronic transfer (based on service charge) .) 2. When expressed in National Currency  Lower rate is favorable (1 U.S.O.0285 U. Exchange 1.o. $ = 26 Rs.)  Higher rate is unfavorable (1 U.$)  Lower rate is unfavorable (1 Rupee = 0.

financial policy (deficit financing in internal value of currency) ‡ Peace and security in a country . Of foreign currencies (BOP situation) (Net surplus or Net Debit in BOPs) ‡Banking Influence BR. Factors affecting rate of exchange ‡Changer in dd & ss.‡Spot Rate and forward Rate Spot Rate: Delivery of foreign exchange is made available to buyer by the seller on the spot. Forward Rate Seller contracts to deliver to the buyer foreign exchange at some future date at a rate settled in the present (includes discount or premium over the spot rate ) Purchasing Power Parity: Relative Price / ends in two countries. CRR ‡Currency Conditions Inflation & Deflation ‡Political Conditions Protection Policy. exchange control.

EXCHANGE CONTROL  When Govt. of a country utilise its foreign exchange earnings for well defined objects as through Central Bank  EC can be partial or full (all currencies) Objectives of EC ‡ To check violent fluctuations in exchange rate (over valuations & under valuation) ‡ To check flight of capital ‡ To remove imbalances in foreign trade ‡ To import essential commodities & import prohibition ‡ To earn foreign exchange from exports ‡ To practice trade discrimination ‡ To earn profits .

‡ Pegging up overvaluation Pegging down undervaluation (Cheaper Exports) Observe: Convertibility of Rupee on Current and capital account .Methods of Exchange Control A. FEMA) Blocked Accounts Multiple Exchange Rates Exchange pegging B. Bilateral ‡ Payment agreement (between creditor & Debtor country) ‡ ‡ Clearing agreements (payment domestic currencies) Transfer moratoria (payment of imported goods & investment on foreign capital is made after lapse of certain pre-determined time) ‡ ‡ ‡ (Authorities are given enough time to solve their FE problem or put their house in order) ST into LI debt or gradual repayment. Unilateral ‡ ‡ ‡ Regulation of BR Regulation of foreign trade Rationing of foreign exchange (FERA.

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