Foreign exchange rate determination

1. FOREIGN EXCHANGE RATE DETERMINATION.
It is the rate at which one currency is exchanged for another. Or it is the
price of one currency in terms of another currency.
In a broader sense it means all those activities through which people make
payments for their transactions in different currencies prevailing in
different parts of the world.
In simple words, exchange rate is the exchange ratio of two currencies.
Eg., $1=Rs.15, it means that one dollar is exchanged for Rs.15.
Exchange rate is also known as external value of as currency.
External value means the number of goods and services that can be bought
with one unit of currency in another country.

2. DETERMINATION OF THE RATE OF EXCHANGE OR POLICIES OF FOREIGN
EXCHANGE RATE.
Three main policies:-
1. Mint Parity Theory.
The theory is associated with the working of the international gold
standard. Under this system the currency in use was made of gold or
was convertible into gold at a fixed rate. The value of currency unit was
defined in terms of certain weight of gold.
The rate at which the standard money of the country was convertible
into gold was called the mint price of gold. When the currencies of
different countries are defined in gold, the exchange rate between two
countries is automatically determined on a weight-to-weight basis of the
gold content of their currencies.

3. Now let us suppose that America and England are on gold standard, and
the British pound contained113.0016 grains of gold and the American
dollar contained 23.2200 grains of gold, then the exchange rate b/n the
British pound and American dollar will be equal to the ratio of the gold
content of two currencies. i.e.,
1pound=113.0016/23.2200=4.866dollars.
The exchange rate so fixed is subject to change. But this variation in
exchange rate is within the well-defined limits called gold points.
The gold points refer to the limits within which the market rate of
exchange b/n two countries of gold standard fluctuate from the mint
Parity equilibrium level. They are determined by the shipping costs from
one country to another which includes transportation packing ,
insurances etc.
The upper gold point is determined by adding the cost of shipping gold
to the mint parity exchange rate.

4. The lower gold point is obtained by deducting the cost of shipping gold
from the mint parity exchange rate.
For eg., if the mint parity rate of exchange for 1 pound =4.866 dollars
and the shipping charge is 2 cent per pound, then
the upper gold point is 1 pound=4.866+.02=4.886 dollars.
the lower gold point is 1 pound=4,866-.02=4.846 dollars.
The upper gold point is called the gold export point because it refers to
the critical rate of exchange at which gold will be exported.
The lower gold point is called gold import point because it indicates the
critical level of exchange below which gold will be imported.
Under the gold standard the exchange rate b/n two currencies will
remain within these two limits.

6. Since the market exchange rate cannot rise above gold export point(OU)
or below the gold import point(OL),the dd and SS curves become
infinitely elastic at the gold points.
The cost of shipping gold determines the upper and lower limits beyond
which the exchange rate cannot move.

7. THE PURCHASING POWER PARITY THEORY.
The theory was put forward by Gustav Cassel to determine the exchange
rate b/n countries on inconvertible paper currencies.
The above theory states that the exchange rate is determined by the
equality of relative change in relative prices in the two countries.
There are two versions:-the absolute and the relative.
The absolute version states that the exchange rate b/n the two
currencies should b equal to the ratio of the price indices in the two
countries.
This version is not used much because it ignores transportation costs
and other factors which hinder trade.
Economists therefore use more the relative version to explain the
purchasing power parity theory.

8. It deals with the determination of the rate of exchange.
The rate of exchange should normally reflect the relationship b/n the
internal purchasing power of the various national currency units.
Eg., if an assortment of goods and services costs Rs. 1300 in India and if
the same costs $100 in the U.S.A., then the purchasing power of
Rs.1300= the purchasing power of$100 Or purchasing power of
Rs.13=Purchasing power of 1$.
This is the accepted exchange rate also known as equilibrium rat e and
if there is any deviation from this rate , the forces of equilibrium will
come into operation and again will restore the equilibrium rate of
exchange.
Now let us suppose that the price level in the two countries remains
the same but the exchange rate moves to $1=Rs.10.

9. It means that the purchasing power of Indian Re.in terms of dollar has
risen, and it is a case of overvaluation of the exchange rate.This will
encourage imports and discourage exports.
People who have surplus rupees will convert them into dollar and thus
earn a profit of Rs 3.
This will increase the dd for dollars in India but the supply of dollars will
decrease because the Indian exports to U.S.A. will fall.
Hence the Indian Re. in terms of dollar will fall until it reaches the
purchasing power parity exchange rate of $1=Rs13.
In the reverse case, if the exchange rate moves to Rs .16=1$, then the
Indian currency becomes undervalued.

10. THE BALANCE OF PAYMENT THEORY OR MODERN THEORY.
This theory is also called DD& SS. Theory.
It says that under free exchange rate, the exchange rate of a
currency depends on its BOPS.
A favourable BOPs raises the exchange rate while an
unfavourable one reduces the exchange rate.
The theory implies that the exchange rate is determined by the
DD.& SS. Of foreign exchange rate.

11. Regarding DD. the theory assumes that rate of exchange has no
influence on it because it is determined by other factors like
payment of international loans , interests thereon, foreign aid and
gifts etc.
SS. of foreign exchange has greater role . If the supply of foreign
exchange earned by a country is large,the value of exchange will
fall and vice-versa.
SS. of foreign exchange is determined by BOP which in turn
influences the determination of exchange rate.

13. In the above diagrame OR is the equilibrium rate of exchange. If the
rate of exchange goes upto OR1, then the SS. Of foreign currency(ON)
will exceed its DD.(OM) . SS being more than DD, rate of exchange
will come down to OR. Contrary to this, if the rate of exchange comes
down to OR2 then the dd. for foreign currency (ON) will be more
than its supply(OM) DD. being more than SS.rate of exchange will rise
to Or. Hence the rate of exchange will be determined at a point
where DD. for and SS. Of foreign currency are equal