This document discusses exchange rate determination. It defines exchange rates as the price of one currency in terms of another. Exchange rates are determined by the forces of supply and demand in foreign exchange markets where currencies are bought and sold. The equilibrium exchange rate is the rate at which demand and supply for foreign currencies are equal. Demand for foreign currency arises from payments to foreign countries for imports and investments. Supply comes from exports, investments, and other receipts from abroad. Several factors can influence exchange rates, including relative inflation rates, interest rates, income levels, government controls, market expectations, speculation, and political/economic conditions.

1. EXCHANGE RATE
DETERMINATION
Dr. Mohamed Kutty Kakkakunnan
Associate Professor
P G Dept. of Commerce
N A M College Kallikkandy
Kannur – Kerala - India

2. EXCHANGE RATE
 What is a market?
 What is market mechanism?
 In a foreign exchange market foreign currencies are
bought and sold
 Transaction involves in two currencies
 One currency = how many foreign currency?
 Relationship is expressed in the form of ratios or rates
 The ratio or rate at which one currency is bought and sold
for another currency – foreign exchange rate
 It is the price of one currency in terms of another
 It specifies the number of units of a given currency that
can be purchased with one unit of other currency

3. Quotations in Foreign Exchange Market
 Two currencies - one in term of other
 Home currency – foreign currency
 Expression of one currency in terms of other
This expression can be made in two ways
• Direct quotation and
• Indirect quotations
 Direct Quotation : Local currencies are expressed in
terms of one unit of foreign currency.
 Direct rate is the rate at which the number of units of
home currency can be bought or sold at per unit of
foreign currency
 Eg: INR 68 = $ 1
This shows that Rs. 68 is required to get one dollar (home
currency varies but foreign currency is fixed)

4. Indirect quote / rate - the number of units of
foreign currency that can be bought or sold per
unit of local currency
In case of indirect quote the exchange rate is
given in terms of units (variable) of foreign
currency as equivalent to a fixed number of
home currency
Eg: $. 0.147 = INR 1
Direct quote expresses per unit of foreign
currency in term of home currency and indirect
quote expresses per unit of local currency in
terms of foreign currency

5. Two-way Quotes (Buying and Selling Rates)
 Different players in foreign exchange market – dealers, brokers etc
 A dealer buys and sells foreign currencies at his own risk
 Usually quote two prices for the same currency
 One for buying and Another for selling
 Buying rate is the rate at which he buys the foreign currency and is
known as bid rate
 Selling rate is the rate at which he sells the same foreign currency and
is known as ask rate
 The difference between these rates represent his profit and is know
as spread
 Spread is the margin or profit of a dealer in foreign exchange market
 Percentage of spread is

6. Determination of Exchange Rates
• Price mechanism
• Market forces
• Equilibrium price
• Equilibrium exchange rate is the at which the
demand for and supply of foreign currency
are equal
• “that rate which over a certain period of time
keeps the balance of payments in
equilibrium”- Regnar Nurkse

7. Demand for Foreign Currency
• Arises from individuals and firms who have to
make payments to foreigners in foreign
currencies (import of goods and services and for
purchases of securities)
Factors affecting demand
1. Price of goods and services in domestic and foreign
countries
2. Import of goods and services
3. Investments made in foreign countries
4. Other payments based on bilateral agreements,
charity etc

8. Supply of Foreign Exchange
Export of goods and services, and other
receipts in the form of investment,
donations, charities and payments based on
bilateral agreements
Factors
1. Export of goods and services
2. Investments
3. Receipts by way of bilateral agreements
4. Donations, charities etc
5. Remittances made by NRIs etc

9. D
D
S
S
Excess
demand
Excess
supply
Equilibrium point
P1
P
P2
A
B
E

10. Factors Influencing Exchange Rate
1. Relative inflation rates
Due to inflation in one country, the goods
become dearer at the same time price level
of the other country remains the same. This
results in import of goods from other
country resulting in the increase of the
demand for the currency of the importing
country.

11. 2. Relative Interest Rates
Difference in interest rates result in the demand and
supply of foreign currency
How?
Investment for earning interest
Citizens of countries where interest rate is low will
invest in countries where there is high interest –
increasing demand for the currency of the investing
country
Increased supply of foreign currency in the investing
country will result in decline of the exchange rate of
foreign currency

12. 3. Relative Income Levels
Increase in the income level of one country will
result in increased consumption and more import
ultimately resulting in the increased demand for
foreign currency
4. Govt. controls and regulations
5. Market expectations
Future expectations about possible increase or
decrease in exchange rates
6. Speculation
7. Changes in bank rates

13. 8. Political conditions
9. Stock exchange activities like sale and purchase
of securities etc.
10. Banking operations (purchase and sale of
foreign exchanges and securities)
11. Credit policy of banks – liberal credit policy
helps speculators to purchase and old foreign
currencies
12. National budgetary influences : Deficit,
balanced and surplus budget – deficit budget
require more resources and lead to exchange rate
decline