Rates of Exchange

Radhakishan V Karthik SJaichander Yasser Farook

DEFINITION

• The rate at which one currency buys or exchanges for another currency is known as the rate of exchange.

• The rate of exchange expresses the external purchasing power of the currency.

• The rate of exchange is a price – the price of one currency in terms of the other.

1 USD = 43.3 Rupees

TERMINOLOGIES

1 SPOT / FORWARD Exchange Rate

2 FIXED / FLEXIBLE / FLOATING Exchange Rate

3 MULTIPLE Exchange Rates

4 TWO TIER Exchange Rate System

SPOT: Currencies are bought and sold according to the current price.FORWARD: They deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement.

FIXED: Currency's value is matched to another measure of valueFLEXIBLE: Keeping the rate fixed over short periods FLOATING: Currency unit of a country is free to fluctuate

If a country adopts more than one rate of exchange for its currency, it is said to follow a system of multiple exchange rates. It may have one rate for exports and another for imports

A form of multiple exchange rates under which the Government maintains two rates – a higher rate for commercial transactions and a lower rate for capital transactions.

THE FOREIGN EXCHANGE MARKET

• The Foreign Exchange Market consists of a number of banks, brokers and dealers engaged in buying and selling foreign exchange and also the central bank of the country and Treasury authorities.

• It is a worldwide decentralized financial market for the trading of currencies.

BASIC FUNCTIONS

DETERMINING THE RATE OF EXCHANGE• The rate of exchange is determined by demand and supply forces -

demand and supply of one currency as against the supply and demand of another currency.

Method 1: Under The Gold Standard – The Mint ParIf two countries are on gold standard and if their currencies are expressed

in terms of weight of gold.

For example, if rupee being equal to 0.1 gram of gold and the dollar is equal to 1 gram of gold, then the rate of exchange between these two currencies will be:

$1 = 1 gram/0.1 gram = Rs.10 (or) Re.1 = 0.1 gram/1 gram = 10 cents,where $1 = 100 cents.

Advantages: Self stabilizing, less debt, no inflation

The actual exchange rate in the foreign exchange market at any particular time will slightly be different from the mint par of exchange.

• Bank commission • Transport & shipping charges

Thus, Re.1 = 9 cents to 11 cents

The lower rate is for the Indians and the higher rate is for the Americans.

Gold Points

• The maximum and minimum rates are also known as gold points. • Any rate above or below the specie points will lead to movement of gold between countries.

Method 2: Under free Paper Currencies – Purchasing Power Parity (PPP)

The previous method depends only on gold reserve and not on general productivity.

The value of a currency will depend upon the price level in that country.

If the level of prices rose, the purchasing power of the currency would fall and hence its value in terms of foreign currency would also fall.

For example, if a bale of cotton is sold for Rs.1000 in India and if the same bale is sold for $100 in the US, the rate of exchange (ignoring transport costs) will be:

$100 = Rs.1000 (or) $1 = Rs.10

Extended PPP Theory

The previous method of comparison is through the medium of one commodity which is traded in both countries.

In the case of all internationally traded goods, prices will tend to be the same in all countries.

It is necessary to take the prices of all goods and services which money helps to purchase.

Thus comparison must be made with the help of general index numbers.

The extended PPP equalizes the purchasing power of different currencies in their home countries for a given Basket of Goods.

More goods and services imply more productivity.

Year Indian IN American IN Exchange Rate

1980 100 100 $1 = Rs 10

1991 250 150 ?

The price quotient is found out by comparing the price changes in the two countries.

When we want to know the exchange rate for India, the price quotient will be the American price index over Indian price index.

The reverse will hold well, when we want to find out the exchange rate for America.

$1 = (250/150) * Rs.10 = Rs.16.67 (or) Re.1 = (150/250) * 10 cents = 6 cents,where $1 = 100 cents.

Criticisms of PPP

• No direct link between purchasing power and rate of exchange.Tariff , capital movements, etc

• Difficulty in comparing price indices.Wholesale, cost of living, agricultural, etc. which one?

• Index number problems.Different types of goods enter into the calculation of index numbers.

• Ignores Foreign Trade RestrictionsImport duties – exchange value of currency will rise even though its internal price remains constant.

• Ignores speculative, political and psychological factors.

• Ignores dynamic factorsTechnological advancement may affect demand, supply and the rate of exchange even when relative prices remain unchanged.

• Change in the exchange rate as the cause• This theory implies that the changes in exchange rate exercise no influence over the price level which is wrong.• Suppose $1 = Rs10 has changed to $1 = Rs 0.10, due to capital movement from America to India.• Indian currency has become costlier to Americans.• Exports from India reduces.• Decline in demand for Indian goods.• Price in India decreases.• American goods become cheaper• Demand for American goods increases, in turn pushing up prices of foreign goods.• Thus national price levels may follow rather than precede the movements of exchange rates.

WHY DOES RATE OF EXCHANGE FLUCTUATE

1 Course of international tradeIf India’s demand for American goods is greater than

vice versa, there is a greater demand for dollar.

2 Monetary PolicyHigh inflation in India will reduce demand for Indian

goods from abroad. Also Indians, would prefer foreign goods.

3 Capital movementsSuppose a large amount of capital is shifted from

America to India. Demand for rupee increases.

4 Speculative activities

FORWARD EXCHANGE MARKET

• Forward transactions consist of contracts to exchange one currency for another at a future date, but at a rate determined now

• PREMIUM: If the demand for foreign currency, in the forward exchange market, is in excess of its supply

• DISCOUNT: When the demand for foreign currency in the foreign exchange market is less than its supply

FIXED AND FLEXIBLE EXCHANGE RATES

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