1. The document discusses different foreign exchange determination systems and exchange rate regimes. It describes purchasing power parity theory and the balance of payments theory, which says exchange rates are determined by demand and supply in the foreign exchange market. 2. It analyzes fixed and floating exchange rate regimes, noting advantages and disadvantages of each. Fixed rates aim to promote trade and investment but lack flexibility, while floating rates automatically adjust for economic imbalances but add uncertainty. 3. Interest rates, inflation, and exchange rates are interrelated, and central banks can influence inflation and exchange rates by adjusting interest rates.

1. Unit IV
Foreign Exchange Determination
Systems

2. Syllabus
Basic Concepts Relating to Foreign Exchange
Various types of Exchange Rate Regimes
Factors Affecting Exchange Rates
Managed, Fixed, Rate Regime
Brief History of Indian Rupee

3. Story
Exchange Rates Regimes of the World, 1870–2007 The shaded regions show the fraction of
countries on each type of regime by year, and they add up to 100%. From 1870 to 1913, the
gold standard became the dominant regime.
During World War I (1914–1918), most countries suspended the gold standard, and
resumptions in the late 1920s were brief.

4. A growth Story
Exchange Rates Regimes of the World, 1870–2007 (continued)
After further suspensions in World War II (1939–1945), most countries were fixed against the
U.S. dollar (the pound, franc, and mark blocs were indirectly pegged to the dollar). Starting in
the 1970s, more countries opted to float. In 1999 the euro replaced the franc and the mark as
the base currency for many pegs.

5. The History Of Currency
• ANCIENT ORIGINS(10000 Year ago)
– barter as money.
– livestock, grains and metals
• THE EVOLUTION OF COIN
– “commodity currencies”
– stones, beads,
– coins were first crafted in the 7th century BC, in the ancient kingdom of Lydia.
• CHINA AND PAPER CURRENCY
– The Chinese were the first to use paper currency.
– promissory notes.
– 1661 – Sweden, 1694 – Bank of England.
– 1786, 1792, 1861 - USA
– Britain was the first to formally adopt a “gold standard” for its currency in
1821

6. Exchange Rate Regime Choice: Key Issues
• What is the best exchange rate regime choice for
a given country at a given time?
• We explore the pros and cons of fixed and
floating exchange rates by combining the models
we have developed with additional theory and
evidence.
• This story highlights the choices policy makers
face as they choose between fixed exchange rates
(pegs) and floating exchange rates (floats).

7. Introduction
• The Foreign exchange market is the market where the
currency of one country is exchanged for that of another
country and where the rate of exchange is determined.
• It serves as tool for
– International Trade
– Foreign Investment
– Lending to and borrowing from foreigners.
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8. Introduction
• 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.”
• “involves the investigation of the method by
which the currency of one country is exchanged
for that of another, the causes which render such
exchange necessary, the forms which such
exchange may take, and the ratios or equivalent
values at which such exchanges are effected”
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9. Participants in the foreign Exchange Market
• Large Commercial Banks operating either at retail
level for individual exporters and corporations, or at
wholesale level in the interbank market.
• Central Banks of various countries that intervene in
order to maintain or to influence the exchange rate
of their currencies within a certain range
• Individual brokers or corporations.
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10. Functions of Foreign Exchange Market
• Transfer of purchasing power:
– Primary function of a foreign exchange market is the
transfer of purchasing power from one country to
another and from one currency to another.
• Provision of Credit:
– Exporter may get pre shipment and post shipment
credit.
• Provision of Hedging facilities:
– Hedging refers to covering of foreign trade risks, and it
provides a mechanism to exporters and importers to
guard themselves against losses arising from
fluctuations in exchange rates.
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11. Methods of affecting International Payment
• Transfers
• Cheques and Bank Drafts
• Foreign Bill of Exchange
– Bill of lading
– The insurance certificate
– Consular invoice
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12. Transaction in the Foreign Exchange Market
• Spot market – Spot Rate
• Forward Market – Forward Exchange Rate
– At par
– At premium
– At discount
– Swap
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13. I. Foreign Exchange Determination Systems
a) Purchasing power parity theory.
b) Balance of payment or the demand and
supply theory.
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14. I. Foreign Exchange Determination Systems
a) Purchasing power parity theory.
• Gustav Cassel – after first world war
• When Exchange rates are free to fluctuate, the rate
of exchange between two currencies in the long run
will be determined by their respective purchasing
powers.
• Absolute and Relative Purchasing power parities:
– Absolute purchasing power parity
– Relative purchasing power parity
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15. I. Foreign Exchange Determination Systems
a) Purchasing power parity theory.
• Absolute Purchasing Power Parity:
• Absolute PPP theory is closely related to the
law of one price which suggests that a product
that is easily and freely traded in a perfectly
competitive global market should have the
same price everywhere, once the price
proposes that the price(P) of the product
measured in domestic currency will be equated
to the price.
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16. I. Foreign Exchange Determination Systems
a) Purchasing power parity theory.
• Relative Purchasing Power Parity: Percentage
change in the bilateral exchange rate is equal
to the difference in the percentage change in
the national price levels over any given period
of time.
• Absolute PPP is a statement about absolute
prices and exchange rate levels, the relative
PPP is a statement about price and exchange
rate changes over time.
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17. I. Foreign Exchange Determination Systems
a) Purchasing power parity theory.
• ER =
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Er x Pd
Pf
ER = Equilibrium exchange rate
Er = Exchange rate in the reference period
Pd = Domestic Price Index
Pf = Foreign country’s price Index

18. I. Foreign Exchange Determination Systems
a) Purchasing power parity theory.
• Demerits:
– The theory makes use of the price index number to
measure the change and hence it is not valid
– The composition of national income varies and hence it
questions the validity of the theory
– The quality of goods and services may vary
– Price index number may include the prices of the product
which are not internationally traded.
– International trade is not free from all barriers
– It does not recognize international capital movement
– The theory does not explain the demand and supply of
foreign exchange
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19. I. Foreign Exchange Determination Systems
a) Purchasing power parity theory.
• Merits
– It indicates the relationship between the internal
price levels and exchange rates
– It explain the state of the trade of a country as
well as the nature of its balance of payments at a
particular time.
– Further, the theory is applicable, to some extent,
to all sort of monetary standard
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20. I. Foreign Exchange Determination Systems
b) Balance of Payment.
• The balance of payment theory, also known as
the demand and supply theory
• General Equilibrium theory of Exchange rate,
holds that the foreign exchange rate, under the
free market condition is determined by the
conditions of demand and supply in the foreign
exchange market.
• The price of a currency i.e. the exchange, is
determined just like the price of any commodity
is determined by the free play of forces of
demand and supply
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21. I. Foreign Exchange Determination Systems
b) Balance of Payment.
Balance of payment:
– In equilibrium = the supply and demand of the
currency remains the same.
– In Deficit = supply of currency exceeds its demand
and causes a fall in the external value of the
currency,
– In surplus = demand exceeds supply and causes a
rise in the external value of the currency
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22. I. Foreign Exchange Determination Systems
b) Balance of Payment.
Evaluation:
• It recognizes the importance of all the items in
determining the balance of payment
• The rate of exchange is determined by the forces
of demand and supply
• General equilibrium theory
• It also suggest that balance of payments
disequilibrium can be corrected by adjustments
in the exchange rate(i.e. by devaluation or
revaluation), rather than by internal deflation or
inflation
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23. III.Various types of Exchange Rate Regimes – Fixed
Rate Regime
• Countries following the fixed exchange rate system agree to
keep their currencies at a fixed, pegged rate and to change
their value only at fairly infrequent intervals, when the
economic situation forces them to do so.
– Development and growth
– Correction of BOP Deficit
– Foreign capital Investment
– Preventing flight of Capital.
– Elimination of Speculation.
– Encouragement to Foreign Trade.
– Encourages regional Grouping.
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24. III.Various types of Exchange Rate Regimes
Flexible/Floating Exchange rate
• Under the flexible exchange rate(also known as floating
exchange rate) system, exchange rates are freely
determined in an open market primarily by private dealings
and they like other market prices, vary from day-to-day.
– Automatic Variations in the exchange rate
– Surplus in the balance of payment – increases the exchange rate
– Deficit in the balance of payment – Decreases the exchange rate
– Flexible exchange rates present a situation of instability, creating
uncertainty and confusion.
– It encourages speculation
– It gives an inflationary bias to an economy.
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25. VIII. Interest Rate
• Interest rates, inflation and exchange rates are all highly correlated.
• By manipulating interest rates, central banks exert influence over
both inflation and exchange rates, and changing interest rates
impact inflation and currency values.
• Higher interest rates offer lenders in an economy a higher return
relative to other countries.
• Therefore, higher interest rates attract foreign capital and cause the
exchange rate to rise.
• The impact of higher interest rates is mitigated, however, if inflation
in the country is much higher than in others, or if additional factors
serve to drive the currency down.
• The opposite relationship exists for decreasing interest rates - that
is, lower interest rates tend to decrease exchange rates.
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26. IX. Factors affecting Exchange Rate
I. Trade Movement
II. Capital Movement
III. Stock Exchange Operations
IV. Speculative Transactions
V. Banking Transaction
VI. Banking Operations
VII. Monetary Policy
VIII.Political Conditions
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27. X. Brief History of Indian Rupees Exchange Rates.
• 6th century BC – Coinage
• Rupees was brought by Sher Shah Suri
• It was evaluated to 40 copper coins.
• The paper currency came into existence after the arrival of Britishers in
the later part of 18th Century
• Bank of Hindustan made the earliest rupee notes issues in the year 1770
• Private and presidency banks issued notes
• The paper currency act in 1861, monopolized by the govt of India.
• 1867 - Ist series of Notes was issued were Victoria Series(5
denominations)
• 1923 – the King Series came into existence and continued till 1935.
• Reserve bank of India took the charge to print Notes after 1935
• King Series was removed in 1947 and new series of notes were launched.
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28. Brief History of Indian Rupees Exchange Rates.
• JOURNEY SINCE INDEPENDENCE
• The Indian currency has witnessed a slippery journey since
Independence. Many geopolitical and economic developments have
affected its movement in the last 66 years.
• When India got freedom on August 15, 1947, the value of the rupee
was on a par with the American dollar. There were no foreign
borrowings on India's balance sheet.
• To finance welfare and development activities, especially with the
introduction of the Five-Year Plan in 1951, the government started
external borrowings. This required the devaluation of the rupee.
• After independence, India had chosen to adopt a fixed rate
currency regime. The rupee was pegged at 4.79 against a dollar
between 1948 and 1966.
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29. Brief History of Indian Rupees Exchange Rates.
• Two consecutive wars, one with China in 1962 and another one
with Pakistan in 1965; resulted in a huge deficit on India's budget,
forcing the government to devalue the currency to 7.57 against the
dollar.
• The rupee's link with the British currency was broken in 1971 and it
was linked directly to the US dollar.
• In 1975, value of the Indian rupee was pegged at 8.39 against a
dollar.
• In 1985, it was further devalued to 12 against a dollar.
• In 1991, India faced a serious balance of payment crisis and was
forced to sharply devalue its currency. The country was in the grip
of high inflation, low growth and the foreign reserves were not
even worth to meet three weeks of imports. Under these
situations, the currency was devalued to 17.90 against a dollar.
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30. Brief History of Indian Rupees Exchange Rates.
• 1993 was very important. This year currency was let free to flow
with the market sentiments. The exchange rate was freed to be
determined by the market, with provisions of intervention by the
central bank under the situation of extreme volatility. This year,
the currency was devalued to 31.37 against a dollar. The rupee
traded in the range of 40-50 between 2000 and 2010.
• It was mostly at around 45 against a dollar. It touched a high of 39
in 2007.
• The Indian currency has gradually depreciated since the global 2008
economic crisis.
• Liberalising the currency regime led to a sharp jump in foreign
investment inflows and boosted the economic growth
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31. Brief History of Indian Rupees Exchange Rates.
• PRESENT SCENARIO
• Indian rupee extended falls to a new low of 65.50 to the dollar as
heavy demand from importers along with weak domestic equities
continued to weigh on sentiment.
• Weakness was also seen after Federal Reserve minutes hinted that
the United States was on course to begin tapering stimulus as early
as next month.
• Moreover, continuing its slide, the rupee also made all time low
against British pound and breached the 102-mark on local bourses.
• With this, British pound has become the first major foreign
currency to cross 100 levels against rupee.
• However, steps taken by the RBI and the government to curb
volatility in the exchange rate have had little effect so far.
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32. Thank You !