The document discusses foreign exchange markets and rates. It provides three reasons for foreign exchange - tourism, international trade, and international investing. Foreign exchange rates are determined by demand and supply in free markets and factors like inflation rates, interest rates, current account deficits, and economic performance affect rates. The purchasing power parity theory suggests exchange rates will equalize purchasing power between currencies in the long run, but this theory has limitations.

1. Foreign exchange markets

2. 1 US dollar= 0.750 euros 1 Euro= 1.3 US dollars

3. Three reasons for foreign exchange
• Tourism
• International Trade
• International Investing

4. What really is traded?
• Bank deposits or bank transfers of deposits
denominated in foreign currency.
• The foreign exchange market exists as a
network of large commercial banks trading
foreign-currency-denominated deposits.
• Legally speaking, physical exchange of money
takes place only in the case of tourism.

6. Determination of Foreign
Exchange Rates

7. Demand and Supply Theory
Determined by free market.
Role of domestic monetary authorities.
Factors determining demand are- economic growth, relative price
stability, and variety of competitive goods and services available for
export.

8. Factors affecting Foreign Exchange
Rates
• Differentials in inflation and interest rate.
• Current account deficits.
• Public debt.
• Terms of trade.
• Political stability and economic performance.

9. Foreign Exchange Market Equilibrium

10. Effect of Domestic Real Interest Rate

11. Effect of Domestic Inflation Rate

12. Effect of Foreign Interest Rate

13. Expectations

14. Purchasing Power Parity Theory
Absolute PPP Relative PPP
• The rate of exchange between two
currencies in the long run will be
fixed by their respective purchasing
powers in their own nations.

15. Absolute Purchasing Power Parity

16. Relative Purchasing Power Parity

17. Criticisms of Purchasing Power Parity
Theory
• Limitations of the Price Index
• Neglect of the demand / supply approach
• Unrealistic Approach
• Unrealistic Assumptions
• Neglects Impact of International Capital Flow.
• Rare Occurrence