Foreign Exchange Market, Purchasing Power Parity, Balance of Payments Theory, Mint theory, Exchange Rate Systems

1. Presented by
Simran Kaur
MBA 2nd year
IGICM
FOREIGN EXCHANGE MARKET

2. INTRODUCTION
• Process of converting one currency into another or foreign
currencies
• H.E.Evitt: “that section of economic science which deals with the
means and methods by which rights to wealth in one country’s
currency are converted into rights to wealth in terms of another
country’s currency”
• 2 interpretations:
a) System or process of converting and transferring money from
one country to other
b) Foreign exchange referred to as foreign currency

3. FUNCTIONS OF FOREIGN EXCHANGE MARKET
• Transfer of purchasing power
• Provision of credit(Euro dollar market)
• Provision of hedging facilities(risks)

4. METHODS OF AFFECTING INTERNATIONAL
PAYMENTS
• Transfers
• Cheques and Bank drafts
• Foreign bill of exchange(unconditional order in writing,
addressed by one person to another, requiring the person to
whom it is addressed to pay a certain sum or demand on a future
date)
• Documentary/Reimbursement credit(opening by importer of a
credit in favor of exporter, at a bank in the exporter’s country)

5. PURCHASING POWER PARITY(PPP)
• Gustav Cassel in First World War: “rate of exchange between two
currencies must stand essentially on the quotient of internal
purchasing powers of these currencies”
• Exchange rates are free to fluctuate, rate of exchange between
two currencies in the long run will be determined by their
respective purchasing powers.

6. DEFINITION OF PPP
• Professor S.E.Thomas. ”while the value of the unit of one
currency in terms of another currency is determined at any
particular time by the market conditions of demand and supply,
in the long run, that value is determined by the relative values of
the two currencies as indicated by their relative purchasing
power over goods and services. The rate of exchange tends to
rest at that point which expresses equality between the
respective purchasing powers of the two currencies.”

7. FORMULA FOR PPP
• Index number of prices may be made use of to determine PPP
• If there is a change in prices, the new equilibrium rate of
exchange can be found out by the formula
ER = Er*(Pd/Pf)
Where ER = equilibrium exchange rate
Er = exchange rate in the reference period
Pd = domestic price index
Pf = foreign country’s price index

8. CRITICISMS FOR PPP
• Suffers from various limitations of the price index numbers
• Types of goods and services included in index number may vary
• Comparison of prices without regard to quality is unrealistic
• Price index number includes the price of all commodities and
services including those which are not internationally traded
• Cost of transportation is ignored
• Assumption of no trade barriers
• Ignores effects of international capital movements on foreign
exchange market

9. CRITICISMS FOR PPP(CONTD.)
• Ignores the impact of changes in the exchange rates on the prices
• Doesn’t explain the demand for supply in foreign exchange
• Starts with a given right of exchange but fails to explain how that
particular rate of exchange is arrived at
• Wrong assumption that elasticity of demand for exports and
imports is equal to unity
• No explanation of short-term changes in exchange rates
• Goes contrary to general experience

10. ASPECTS OF PPP
• Relationship between the internal price levels and exchange
rates
• Explains state of the trade of a country as well as nature of its
balance of payments at a particular time
• Applicable to all sorts of monetary standards

11. BALANCE OF PAYMENTS THEORY
• Also known as Demand and Supply theory and the General
Equilibrium Theory of exchange rates
• Foreign exchange rate, under free market conditions, is
determined by the conditions of demand and supply in foreign
exchange market
• Value of currency appreciates when demand for it increases and
depreciates when the demand falls, in relation to its supply in the
foreign exchange market
• When the balance of payments is in equilibrium, the supply of
and demand for the currency are equal

12. MERITS OF BALANCE OF PAYMENTS
• Recognizes the importance of all items in balance of payments
• It is in conformity with the General theory of value
• Determination of rate of exchange within purview of General
equilibrium theory
• Disequilibrium can be corrected by adjustments in the exchange
rate, rather than by internal inflation or deflation

13. MINT PARITY
• Associated with the working of the International Gold Standard.
(gold standard operated between 1880—1914 )
• The currency in use was made of gold or convertible into gold at
a fix rate
• The value of one currency unit was defined in terms of certain
weight of gold, that is, how many grains of gold is equal to one
dollar or one pound etc.

14. ASSUMPTIONS OF MINT PARITY
• It buys and sells gold in any amount at that price.
• Supply of money consists of gold or paper currency which is
backed by gold.
• There is movement of gold between countries
• Capital is moveable within countries.
• Price directly varies with money supply

15. CRITICISMS OF MINT PARITY
• None of the modern countries in the world is gold or metallic
standard
• Based on the free buying and selling of gold and its movement
between countries , while Govt. do not allow such sales or
purchases and movement
• The theory is fails to explain the determination of exchange rates
as most countries are on inconvertible paper currencies

16. TYPES OF EXCHANGE RATE SYSTEMS
• There are two important exchange rate systems, namely
1. Fixed exchange rate
2. Flexible exchange rate

17. FIXED EXCHANGE RATES
• Known as stable exchange rate and pegged exchange rate
• Keep currencies at a fixed, pegged rate and to change their value
only at fairly infrequent intervals
• Under the gold standard, the value of currencies were fixed in
terms of gold

18. ARGUMENTS FOR FIXED EXCHANGE RATE
SYSTEMS
• Orderly development and growth of foreign trade
• Prevent continuous depreciation of external value of their
currencies
• Attract foreign capital investments
• Prevent outflow of capital
• Eliminates speculation in foreign exchange market
• Successful functioning of regional groupings and arrangements
among nations
• Growth of international money and capital market

19. FLEXIBLE EXCHANGE RATE
• Exchange rates are freely determined in an open market
primarily by private dealings
• First impact of any tendency towards a surplus or deficit in
balance of payments is on exchange rate
• Automatic variations in the exchange rates tend to restore
balance of payments equilibrium
• Encourages imports and discourages exports

20. ARGUMENTS AGAINST FLEXIBLE EXCHANGE
RATES
• Present situation of instability, creating uncertainty and
confusion
• Exporters and importers not certain about price they will have to
pay or receive for foreign exchange
• Dampening effect on the volume of foreign trade
• Widespread speculation
• Inflationary bias to an economy

21. TYPES OF EXCHANGE RATE REGIMES
• Single currency peg(country pegs to a major currency-US$ or
French franc-with infrequent adjustments of parity)
• Limited flexibility vis-à-vis a single currency(value of currency
maintained within certain margins of peg-applies to 4 Middle
East countries)
• Limited flexibility through cooperative arrangements(applied to
countries in exchange rate mechanism of European Monetary
System or EMS-cross between peg of individual EMS currency to
each other and a float of all these currencies jointly vis-à-vis non-
EMS currencies)

22. TYPES OF EXCHANGE RATE REGIMES(CONTD.)
• Composite currency peg(country pegs to a basket of currencies
of major trading partners to make pegged currency more stable)
• Greater flexibility through adjustment to an indicator(currency
is adjusted more or less automatically to changes in selected
indicators)
• Greater flexibility through managed float(Indicators for
adjusting the rate include, for example, balance of payments
position, reserves and parallel market developments)
• Full flexibility through an independent float(rates determined by
market forces)

23. FACTORS INFLUENCING EXCHANGE RATES
• Inflation rates(directly affects)
• Interest rates(directly affects)
• Balance of payments(directly affects)
• Government debt(directly affects)
• Terms of trade(directly affects)
• Political stability(indirectly affects)
• Recession(directly affects)
• Speculation(directly affects)

24. THANK YOU!!!