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# Exchange rate determination

## by Pankaj Kumar, Self employed consultant, at Kushmanda Manpower on Feb 25, 2011

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## Exchange rate determinationPresentation Transcript

• Exchange Rate Determination Unit 3 Chapter 3
• Introduction
• An Exchange rate is the price of one nation’s currency 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 the number of dollars one Rupees will buy… following the same example the exchange rate would be \$0.01 / Rs.
• When a currency becomes more valuable relative to another currency it is said to be appreciated . The price of 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 price of the foreign exchange has risen (e.g. 1 USD buys Rs. 39 instead of Rs. 45 )
• Exchange Rate Determination
• It is determined by the equilibrating interaction of buyers and sellers of currencies in the FOREX market: demand and supply determine exchange rates.
• Demand for a currency for making payments for foreign trade and capital flows.
• Supply of a currency, during foreign trade.
• Exchange Rate Equilibrium
• An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.
\$\$\$
• Exchange Rate Equilibrium e D D S S Quantity of Rupees Value of Rupees
• Factors Affecting Exchange Rate
• Relative Inflation Rate:
• U.S. inflation 
•  U.S. demand for Indian goods, and hence Rs.
•  Indian desire for U.S. goods, and hence the supply of Rs.
• Relative Interest Rate:
• U.S. interest rates 
•  U.S. demand for Indian bank deposits, and hence demand for Rs.
•  Indian desire for U.S. bank deposits, and hence the supply of Rs.
• Factors contd..
• Relative Income Levels:
• U.S. income level 
•  U.S. demand for Indian goods, and hence Rs.
• No expected change for the supply of Rs.
• Political and Economic Risk:
• Investors prefer to hold lesser amounts of riskier assets, thus, low risk currencies—those associated with more politically and economically stable nations—are more highly valued than high risk currencies.
• Theories of Exchange Rate
• Balance of Payments Theory
• PPP theory
• Given by Gustav Cassel.
• According to this theory, the price levels and the changes in the price levels in different countries determine the exchange rates of these country’s currencies.
• This theory is based on the principle that the exchange rates between various currencies reflect the purchasing power of these currencies.
• It is thus based on the law of One Price.
• PPP THEORY contd..
• assumptions of Law of One Price are:
• There is no restriction on the movement of goods between countries.
• There is no transportation cost involved.
• There is no transaction cost involved in the buying and selling of goods.
• There are no tariffs involved.
• Example: US/French exchange rate: \$1 = .78Eur A jacket selling for \$50 in New York should retail for 39.24Eur in Paris (50x.78).
• PPP THEORY contd..
• According to this theory, the price of a commodity should remain the same across the world. If not then arbitrageurs would buy from cheaper market and sell them in dearer market till price would become same in both countries/markets.
• Another way to explain it is, that in equilibrium where domestic purchasing powers at the rate of exchange are equivalent.
• Therefore, the rate of exchange tends to rest at that point which expresses equality between the respective purchasing powers of the two currencies. This point is called Purchasing Power Parity.
• PPP THEORY contd..
• Reasons why PPP is not perfect:
• PPP numbers can vary with the specific basket of goods used, making it a rough estimate.
• Preferences and choices can vary from country to country. Goods then differ in their contribution to welfare.
• International competitiveness is mainly affected by the exchange rate and not by PPP.
• Differences in quality of goods are not sufficiently reflected in PPP.
• Assignment Question
• Explain Balance of Payment Theory?