Foreign Exchange Management (3)

8/13/2019 Foreign Exchange Management (3)

1/65

UNIT I

FOREIGN EXCHANGE MANAGEMENT

Q. What are the Sources of demand for and supply of foreign Exchange? AlsoExplain the Process of Determination of Exchange Rate.

Ans. Meaning of Foreign Exchange: Foreign Exchange is the system or process ofconverting one national currency into another and of transferring the ownership of moneyfrom one country to another country.

Meaning of Exchange Rate: Exchange rate is the rate at which one currency can beexchanged for another.

Sources of Demand for Foreign Exchange :- The demand for foreign currency comesfrom individuals and firms who have to make payments to foreigners in foreign currency. Thevarious sources are:-

(i) Import Companies

(ii) Foreign Investors

(iii) Speculators(iv) Lending to Foreigners.

Relation between Exchange Rate and Demand for Foreign Exchange: There is aninverse relation between exchange rate and demand for foreign exchange. It states thatwhen exchange rate increases, demand for foreign exchange decreases and whenexchange rate decreases, demand for foreign exchange increases. There may be twosituations:-

(i) When Exchange Rate Increases:- When exchange rate increases, the importsbecomes costlier and the importers curtail the demand for imports. Consequently, thedemand for foreign currency falls.

(ii) When Exchange Rate Decreases:-When exchange rate decreases, the importsbecomes cheaper and the importers increase the demand for imports. Consequently,the demand for foreign currency increases.

This relation can be shown with the help of Diagram. Suppose a person wants to changeRupees into U.S. Dollar.


2/65

INTERNATIONAL FINANCIAL MANAGEMENT

Explanation:-In this figure Demand for US $ is shown on Horizontal axis i.e. OX-axis andthe exchange rate designated by the price of the US dollar(foreign currency) in terms of therupee is shown on Vertical axis i.e. OY-axis. DD is the Demand curve for US$. DD curverepresents that when exchange rate increases from OE to OE1, then demand for US$decreases from OQ to OQ1. DD curve slopes downward to the right. It shows a negativerelation between exchange rate and demand for foreign currency.

Shifting of Demand Curve:- There are two possibilities:-

(i) When demand increases:- When demand for foreign currency increases thendemand curve will move to the right. It can be explained with the help of followingdiagram:-

YD

E1

ExchangeRate

E

O Q1 Q XDemand for US $

D

YD

D1

Exchange

Rate

DD1

O Demand for US $ X


3/65

(ii) When demand Decreases:- When demand for foreign currency decreases thendemand curve will move to the left. It can be explained with the help of following

diagram:-

Sources of Supply of Foreign Exchange:- The supply of foreign results from the receiptof foreign currency. There are various sources:-

i) Exports Companies

ii) Foreign Investors

iii) Speculators

iv) Borrowings from Foreigners.

Relation between Supply of Foreign Exchange and Exchange Rate: There is a positiverelation between exchange rate and supply of foreign exchange. It states that whenexchange rate increases, supply of foreign exchange will also increases and whenexchange rate decreases, supply of foreign exchange will also decreases. There may betwo situations:-

i) When Exchange Rate Increases:- When exchange rate increases, theexports earnings will also increase. Consequently, the supply of foreigncurrency increases.

ii) When Exchange Rate Decreases:- When exchange rate decreases, theexports earnings will also decrease. Consequently, the supply of foreigncurrency decrease.

This relation can be shown with the help of Diagram.

YD1

D

ExchangeRate

D1D

O Demand for US $ X


4/65

Explanation:- In this figure Supply of US $ is shown on Horizontal axis i.e. OX-axis and theexchange rate designated by the price of the US dollar(foreign currency) in terms of therupee is shown on Vertical axis i.e. OY-axis. SS is the Supply curve of US$. SS curverepresents that when exchange rate increases from OE to OE1, then supply of US$ will alsoincreases from OQ to OQ1. SS curve slopes upward to the right. It shows a positive relationbetween exchange rate and supply of foreign currency.

Shifting of Supply Curve:- There are two possibilities:-

(i) When Supply Increases:- When supply of foreign currency increases then supplycurve will move to downward . It can be explained with the help of following diagram:-

(ii) When Supply Decreases:- When supply of foreign currency decreases then supplycurve will move to upward. It can be explained with the help of following diagram:-

YS

E1

ExchangeRate

E

S

Q Q1

YSupply of US $

Y S

ExchangeRate

S1

O Supply for US $ X

S1

S


5/65

Process of Determination of Exchange Rate:-

It is the interplay of demand and supply forces that determines the exchange rate betweentwo currencies. The exchange rate between, say, the rupee and the US dollar depends uponthe demand for the US dollar and supply of US dollar in the Indian foreign exchange market.The process of determination of rate of exchange can be explained with the help of followingdiagram:-

Y

S1

E1

Rs/US$

E

S

Q Q1O XQ2

Demand for and supply of US$

S

S1D

D

D1

D1

Y S1

ExchangeRate

S

O Supply for US $ X

S

S1


6/65

Explanation: In this figure the exchange rate designated by the price of the US dollar

(foreign currency) in terms of the rupee is shown on the OY-axis and the supply of and

demand for the US dollar is shown on the OX-axis. The demand curve slopes downward tothe right. The supply curve slopes upward to the right. The equilibrium exchange rate arrives

where the demand curve intersects the supply curve. In this figure demand curve DD

intersect supply curve SS at point M and so exchange rate is determined OE. If the demand

for import rises owing to some factors at home, the demand for the US dollar will rise to D1D1

and intersect to supply at point N. The exchange rate will be OE1. But if the export rises as a

sequel to decline in the value of rupee and supply of dollar increases to S1S1, the exchange

rate will again be OE. Quite evidently, frequent shifts in demand and supply conditions cause

the exchange rate to adjust frequently to a new equilibrium.

Q. Explain the Balance of Payment in detail.

Ans. Balance of payments: Balance of payments is a statement listing receipts andpayments in the international transactions of a country. In other words, it records the inflow

and the outflow of foreign exchange. The system of recording is based on the concept of

double entry book keeping, where the credit side shows the receipts of foreign exchange

from abroad and the debit side shows payments in foreign exchange to foreign residents.

Disequilibrium does occur, but not form accounting point of view because debit and credit

balances equal each other if the various entries are properly made.

Again receipts and payments are compartmentalized into two heads:

(1) Current Account: The current account records the receipts and payments of foreign

exchange in the following ways. They are:

Current Account Receipts Current Account Payments

Export of Goods Imports of Goods

Invisibles: Invisibles:

Services Services

Unilateral transfers Unilateral transfers

Investment Income Investment Income

Non-monetary movement of gold Non-monetary movement of gold

The explanations are:

(i) Export and Imports of Goods: Export of goods effects the inflow of foreign

exchange into the country while import of goods causes outflow of foreign

exchange from the country. The difference between the two is known as the

balance of trade.


7/65

If export exceeds import, balance of trade is in surplus.

Excess of import over export means deficit balance of trade.

(ii) Exports of Invisibles: Trade in services embraces receipts and payments onaccount of travel and tourism, financial charges concerning banking, insurance,transportation and so on. Investment income includes interest, dividend andother such receipts and payments.

(iii) Non-monetary movement of gold: There is another item in the currentaccount, known as non-monetary movement of gold. It may be noted that thereare two types of sale and purchase of gold. One is termed as monetary sale andpurchase that influences the international monetary reserves. The other is non-monetary sale and purchase of gold. This is for industrial purposes and is shownin the current account.

(2) Capital Account: Similarly capital account transactions take place in the followingways:

Capital Account Receipts Capital Account Payments

Long term inflow of funds Long term outflow of funds

Short term inflow of funds Short term outflow of funds

The flow on capital account is long-term as well as short-term. The difference betweenthe two is that the former involves maturity over one year, while the short-term flowsare affected for one year or less.

(i) The credit side records the official and private borrowing from abroad net ofrepayments, direct and portfolio investment and short-term investments into thecountry.

(ii) The debit side includes disinvestment of capital, country's investment abroad,loans given to foreign government or a foreign party and the bank balances heldabroad

Balance of Payments

Balance of Trade = Export of goods-Imports of goods

Balance of Current Account= Balance of Trade + Net Earnings on Invisibles

Balance of Capital Account = Foreign exchange inflow - Foreign exchangeoutflow, on account of foreign investment, foreign loans, banking transactions,and other capital flows

Overall balance of payments= Balance of current account + Balance of capitalaccount


8/65

Definition of Balance of Payment

According to Kindleberger

"The balance of payment of a country is a systematic record of all economictransactions between its resi

Features of Balance of Payments:

(1) Systematic Records:It is a systematic record of receipts and payments of a countrywith other countries.

(2) Fixed Period of time:It is a statement of account pertaining to a given period of time,usually one year.

(3) Comprehensiveness: It includes all the three items, i.e.,

Visible

Invisible

Capital Transfers

(4) Double Entry System:Receipts and payments are recorded on the basis of doubleentry system.

(5) Adjustment of Differences:Whenever there is difference in actual total receipts andpayments, need is felt for necessary adjustment.

(6) All items-Government and Non-Government: Balance of payments includesreceipts and payments of all items government and non-government.

Q. What are the different approaches for adjustment of Balance of Payments?

Ans. Different Approaches to Adjustment:(A) The Classical View:Classical economists were aware of the balance of payments

disequilibrium, but they were of the view that it was self adjusting. Their view, whichwas based on the price-specie-flow mechanism, stated that an increase in moneysupply raises domestic prices, where by exports become uncompetitive and exportearnings drop. Foreign goods become cheaper, and imports rise, causing the currentaccount balance to go into deficit in the sequel. Precious metal leaves the country inorder to finance imports. As a result, the quantity of money lessens, that lowers theprice level. Lower prices in the economy lead to greater export and trade balancesreaches equilibrium once again.

(B) Elasticity Approach:After the collapse of the gold standard, the classical view could

not remain tenable. The adjustment in the balance of payments disequilibrium wasthought of in terms of changes in the fixed exchange rate, that is through devaluationor upward revaluation. But its success was dependent upon the elasticity of demandfor export and import. Marshall and Lerner explained this phenomenon through the"elasticity" approach.


9/65

The elasticity approach is based on partial equilibrium analysis where everything isheld constant, except for the effects of exchange rate changes on export or import.

There are some other assumptions:-

(i) The elasticity of supply of output is infinite so that the price of export in homecurrency does not rise as demand increases.

(ii) Elasticity approach ignores the monetary affects of variation in exchange rates.

Based on these assumptions, devaluation helps improve the current balance only if:

Em + Ex > 1

Em = Price Elasticity of demand for import.Ex = Price Elasticity of demand for export.

If the elasticity of demand is greater than unitary, the import bill will contract and exportearnings will increase. Trade deficit will be removed. When the devaluation of currencyleads to a fall in export earnings in the initial stage and then a rise in export earnings, makingthe earning curve look like the alphabet, J it is called J-curve effect.

J-curve can be explained with the help of following diagram:-

Explanation: - In this figure time is shown on OX- axis and Balance of trade is shown on OY-axis. Trade balance moves deeper into the deficit zone immediately after devaluation. Butthen it gradually improves and crosses into surplus zone. The curve resembles the alphabet,J and so, it is known as the J-curve Effect.

Currency

Depreciation

Trade balance eventually improves

Trade balance initially deteriorates

+ -

- -

0


10/65

Criticism:- The weakness of the elasticity approach is that it is a partial equilibrium analysisand does not consider the supply and cost changes as a result of devaluation as well as theincome and the expenditure effects of exchange rate changes. In this context, it may bementioned that it was Stern (1973) who incorporated the concept of supply elasticity in theelasticity approach. According to him, devaluation could improve balance of payments onlywhen:

Where X = Exports

M = Imports.

EDx = Elasticity of demand for exports

ESx = Elasticity of supply for exports

EDm = Elasticity of demand for imports

ESm= Elasticity of supply for imports.

(C) Keynesian Approach: The Keynesian view takes into consideration primarily theincome effect that was ignored under the elasticity approach. Here the readers areacquainted with three different views that are based on the Keynesian approach.

(1) Absorption Approach: The absorption approach explains the relationshipbetween domestic output and trade balance and conceives of adjustment in adifferent way. Sidney A. Alexander treats balance of trade as a residual given bythe difference between what the economy produces and what it takes fordomestic use or what it absorbs. He begins with the contention that the totaloutput is equal to the sum of consumption, investment, government spendingand net export. In the form of an equation,

Y = C + I + G + (X-M)

Y = Total output C = Consumption

I = Investment G = Government spending

X-M = Net export

Substituting C+I+G by absorption, A, it can be rewritten as:

Y = A + X-M

Y-A= X-M

This means that the amount by which total output exceeds total spending orabsorption is represented by net export, which means a surplus balance of trade. Thisalso means that if A>Y, deficit balance of trade will occur. This is because excess


11/65

absorption in the absence of desired output will cause imports. Thus, in order to bringequilibrium to the balance of trade, the government has to increase output or income.

Increase in income without corresponding and equal increase in absorption will lead toimprovement in balance of trade. This is called the expenditure switching policy.

(2) Mundell's View:Mundell also incorporates interest rate and capital account inthe ambit of discussion. In his view it is not only government spending but alsointerest rate that influences income as well as balance of payments. While largergovernment spending increases income, an increase in income leads to rise inimport. With a positive marginal propensity to import, any rise in income as asequel to increase in government spending will lead to greater imports andworsen the current account. However, changes in interest rate influence boththe capital account and the current account. A higher interest rate will lead toimprovement in current account through lowering of income. At the same time, a

higher interest rate will improve the capital account by attracting foreigninvestment flow.

(3) New Cambridge School Approach: This is a special case of absorptionapproach. It takes into account savings, investment, taxes and governmentspending and their impact on the trade account. In the form of an equation, it canbe written as:

S+T+M = G+X+I

OR (S-I) + (T-G) + (M-X) = 0

OR (X-M) =(S-I) + (T-G)

The theory assumes that (S-I) and (T-G) are determined independently of each other

and of the trade gap. (S-I) in normally fixed as the private sector has a fixed net level ofsaving. And so the balance of payments deficit or surplus is dependent upon (t-G) andthe constant (S-I). In other words, with constant (S-I) , it is only the manipulation of (T-G) that is necessary and a sufficient tool for balance of payments adjustment.

(D) Monetary Approach: Monetarists believe that the balance of paymentsdisequilibrium is a monetary and not a structural phenomenon. To explain thephenomenon, it is assumed that

(1) Demand for money depends upon the domestic price level and real income. Therelationship among these three variables does not change significantly overtime. In form of an equation, it can be written as:

L = kPY

Here,

L = Demand for money


12/65

P = Domestic Price Level

Y = Real Income

(2) Money supply depends upon domestic credit and international reserves held

and money multiplier. It can be written as

M = (R+D)m

Here,

M = Money Supply

R = International Reserves

D = Domestic credit

m = Money multiplier

(3) Domestic price level depends on the foreign price level, and the domestic

currency price of foreign current, we can write it as

P = EP*

Here,

P = Domestic Price Level

P* = Foreign Price Level

E = Domestic currency price of foreign currency.

(4) Demand for money equals the supply of money because there is held an

equilibrium in the money market, which is

L = M

The process of adjustment varies among the types of exchange rate regime the country has

opted for .

(i) Fixed Exchange Rate Regime : In a fixed exchange rate regime or in gold standard,

if the demand for money, that is the amount of money people wish to hold, is

greater than the supply of money, the excess demand would be met through the

inflow of money from abroad.


13/65

On the contrary, with the supply of money being in excess of the demand for it,the excess supply is eliminated through the outflow of money to other countries.

The inflow and outflow influence the balance of payments.

(ii) Floating Exchange Rate Regime :However, in a floating rate regime, the demand formoney is adjusted to the supply of money via changes in the exchange rate. Especiallyin a situation when the central bank makes no market intervention, the internationalreserves component of the monetary base remains unchanged. The balance ofpayments remains in equilibrium with neither surplus nor deficit. The spot exchangerate is determined by the quantity of money supplied and the quantity of moneydemanded.

When the central bank increases domestic credit through open market operations, thesupply of money is greater than the demand for it. Households increase their importsand with increased demand for imports, the domestic currency will depreciate and it

will continue depreciating until the supply of money equals the demand fore money.Conversely, with decrease in domestic credit, the households reduce their import.Domestic currency will appreciate and it will continue appreciating until supply ofmoney equals demand for money.

Q. Write a short note on following:-

(A) Nominal Exchange Rate

(B) Real Exchange Rate

(C) Effective Exchange Rate

Ans:-

(A) Nominal Exchange Rate :- The nominal exchange rate is the price in domesticcurrency of one unit of a foreign currency. In other words, the value of a country's currency inrelation to other currencies without adjustment for the rate of inflation.

The nominal exchange rate is defined as the number of units of the domestic currency thatcan purchase a unit of a given foreign currency. There are two situations:-

(ii) A decrease in this variable is termed nominal appreciation of the currency.

(iii) An increase in this variable is termed nominal depreciation of the currency.

Thus we can say that nominal exchange rate tell us the purchasing power of our owncurrency in exchange for a foreign currency. It does not reflect changes in prive levels in thetwo nations.

(B) Real Exchange Rate:- The real exchange rate is defined as the ratio of the domesticprice level and the price level abroad, where the latter is converted into domesticcurrency units via the current nominal exchange rate.


14/65

Formally,

PdQ = ----------Pf

where

Q = Real Exchange Rate

Pd = Domestic price level

Pf =Foreign Price Level

This rate tells us how many times more goods and services can be purchased abroad(after conversion into a foreign currency) than in the domestic market for a given amount. Inpractice, changes of the real exchange rate rather than its absolute level are important. Anincrease in the real exchange rate Q is termed appreciation of the real exchange rate, adecrease is termed depreciation. In contrast to the nominal exchange rate, the realexchange rate is always 'floating", since even in the regime of a fixed nominal exchange rate, Q can move via price-level changes.

The real exchange rate adjusts the nominal exchange rate for changes in nation'sprice levels and thereby measurers the purchasing power of domestic goods and services inexchange for foreign goods and services.

Equation of Real Exchange Rate:-

et (1+ IA)t---- = --------------e0 (1+ IB )t

e0 = A' currency value for one unit of B's currency at the beginning of the period.

et = Real exchange rate in period t

IA = Rate of Inflation in A country

IB = Rate of Inflation in B Country.

For Example:- If India has an inflation rate of 5 per cent and the United State of America hasa 3 per cent rate of inflation and if the initial exchange rate is Rs. 40/US$, the value of therupee in a two year period will be:-

(1.05)2et = 40 X ---------------

(1.03)2

= Rs. 41.57/US$

Such an inflation-adjusted rate is known as the real exchange rate.


15/65

(C) Effective Rate of Exchange :-The weighted average of a country's currency relativeto an index or basket of other major currencies adjusted for the effects of inflation. The

weights are determined by comparing the relative trade balances, in terms of onecountry's currency, with each other country within the index.

This exchange rate is used to determine an individual country's currency value relativeto the other major currencies in the index, as adjusted for the effects of inflation. Allcurrencies within the said index are the major currencies being traded today: U.S.dollar, Japanese yen, euro, etc.

This is also the value that an individual consumer will pay for an imported good at theconsumer level. This price will include any tariffs and transactions costs associatedwith importing the good

Nominal Effective Exchange Rate:- The unadjusted weighted average value of a

country's currency relative to all major currencies being traded within an index or poolof currencies. The weights are determined by the importance a home country placeson all other currencies traded within the pool, as measured by the balance of trade.

Real Effective Exchange Rate:- The weighted average of a country's currencyrelative to an index or basket of other major currencies adjusted for the effects ofinflation. The weights are determined by comparing the relative trade balances, interms of one country's currency, with each other country within the index.

Q. Explain Purchasing Power Parity (PPP) Theory.

Ans. Purchasing Power Parity Theory:-There are two versions of Purchasing PowerParity theory :-

(1) Absolute Version of the PPP theory.(2) Relative Version of the PPP theory.

(1) Absolute Version of the PPP theory:- The PPP theory suggests that at any point oftime, the rate of exchange between two currencies is determined by their purchasingpower.

If e is the exchange rate and PA and PB are the purchasing power of the currencies inthe two countries, A and B, the equation can be written as

PAe = -------

PB

In fact, this theory is based on the theory of one price in which the domestic price of anycommodity equals its foreign price quotes in the same currency. To explain it, if theexchange rate is Rs.2/US$, the price of a particular commodity must be US$50 in theUnited state of America if it is Rs. 100 in India. In other words


16/65

US$ price of a commodity X Price of US$ = Rupee price of the commodity

If inflation in one country causes a temporary deviation from the equilibrium,arbitrageurs will begin operating, as a result of which equilibrium will be restoredthrough changes in the exchange rate.

For Example:- Suppose, the price of the commodity soars up in India to Rs. 125, thearbitrageurs will buy that commodity in the United States of America and sell it in Indiaearning a profit of RS. 25. This will go on till the exchange rates moves to Rs. 2.5/US$and the profit potential of arbitrage is eliminated.

The exchange rate adjustment resulting from inflation may be explained further. If theIndian commodity turns costlier, its export will fall. At the same time, its import from theUnited States of America will expand as the import gets cheaper. Higher import willraise the demand for the US dollar raising, in turn, its value vis--vis rupee.

Limitation of Absolute Version:-However this version of the theory holds good, ifthe same commodities are included in the same proportion in the domestic marketbasket and the world market basket. Since it is normally not so, the theory faces aserious limitation. Moreover, it does not cover non-traded goods and services, wherethe transactions cost is significant.

(2) Relative Version of the PPP theory:-In view of the above limitation, another versionof this theory has evolved, which is known as the relative version of the PPP theory.The relative version of PPP theory states that the exchange rate between thecurrencies of the tow countries should be a constant multiple of the general priceindices prevailing in two countries. In other words, percentage change in theexchange rates should equal the percentage change in the ratio of price indices in the

two countries. To put it in the form of an equation, where I A and IB are the rates ofinflation in country A and country B, e0 is the A' currency value for one unit of B'scurrency at the beginning of the period and et is the spot exchange rate in period t,then

et (1+ IA)t----- = ---------------e0 (1+ IB )t

e0 = A' currency value for one unit of B's currency at the beginning of the period.

et = Spot exchange rate in period t

IA = Rate of Inflation in A country

IB = Rate of Inflation in B Country.

For Example:- If India has an inflation rate of 5 per cent and the United State of America hasa 3 per cent rate of inflation and if the initial exchange rate is Rs. 40/US$, the value of therupee in a two year period will be:-


17/65

(1.05)2et= 40 X --------------

(1.03)2

= Rs. 41.57/US$

This theory suggests that a country with a high rate of inflation should devlauate its currencyrelative to the currency of the countries with lower rates of inflation.

Conclusion:-

Merits:- PPP theory holds good if:

(1) Changes in the economy orginate from the monetary sector.

(2) There is no structural changes in the economy, such as changes in tariff and intechnology.

Demerits:- PPP theory does not hold good in following situations:-

(1) The assumptions of this theory do no necessarily hold good in real life.

(2) There are other factors such as interest rates, governmental interference and soon that influence the exchange rate.

Q. Explain Monetary Approach of Exchange Rate.

Ans. Monetary Approach:-Moneatry Approach is divided into two sections:-

(1) Monetary Approach of Flexible Price Version.

(2) Monetary Approach of Sticky-price Version.

1. Monetary Approach of Flexible Price Version:- The monetary approach of theflexible price version emphasises the role of demand for money and the supply ofmoney in determination of the exchange rate. The exchange rate between twocurrencies, accordingly to this approach, is ratio of the value of two currenciesdetermined on the basis of the two countries money supply and money demandpositions. There are three situations:-

(i) Any increase in money supply raises the domestic price level and the resultantincrease in price level lowers the value of the domestic currency. It can also beexplained with the help of following equation:

Increase in Money Supply Higher Price Level

Depreciation of domestic currency.

(ii) If the increase in money supply is lower than theincrease in real domesticoutput, the excess of real domestic output over the money supply causes


18/65

excess demand for money balances and leads to a lowering of domestic prices,which causes an improvement in the value of domestic currency.

Money Supply being less than real domestic output excessdemand for money balances lower domestic pricesAppreciation of domestic currency.

(iii) Monetary theory explains that a rise in domestic interest rate lowers the demandfor money in the domestic economy relative to its supply and thereby causesdepreciation in the value of domestic currency.

Rise in interest rate lower demand for moneydomestic currency depreciates.

Criticism:- However, critics of this theory argue that this theory does not hold good inthe short run.

(2) Monetary Approach of Sticky-Price Version:- The sticky price version makes amore detailed study of interest rate differential. The argument in favour of thisapproach is that an increase in money supply (through changes in the real interest ratedifferential) leads to depreciation in the value of domestic currency.

Assumptions:-

The monetary approach of the sticky price version rests on a couple of assumptions.

Money Supply is Endogenous:- The money supply in a country isendogenous, meaning that it is positively related to the market interest rate.

PPP Theory applies in long run:-The second assumption is that the PPP

theory applies in the long run and so the expected inflation differential changeshave a role to play in the determination of the exchange rate.

Explanation:-The sticky price theory can be explained in two sections:-

(A) Study of Interest Rate Differential:-The sticky price version makes a detailedstudy of interest rate differential. The interest rate differential has threecomponents:-

(i) One denotes that when the interest rate rises, the money balances held bythe public come to the money market in lure of high interest rate. Moneysupply increases leading to currency depreciation.

Increase in Money Supply Depreciation of domestic currency.

(ii) Second denotes that if interest rate rises, financial institutions increasethe funds to be supplied to the money market. Money supply increasesand the value of domestic currency depreciates.


19/65

Rise in Interest Rate Increase in money supply (loanable funds)Depreciation of domestic currency.

(iii) The third is that a rise in interest rate stimulates the capital inflow into thecountry that, like the balance of payments approach, causes appreciationin the value of domestic currency.

Rise in Interest Rate Greater inflow of capitalAppreciation of domestic currency.

(B) Study of Inflation Rate Differential:- The sticky price version specially mentions theexpected inflation rate differential. A rise in inflation rate compared to that in the foreigncountry leads to depreciation in the value of domestic currency. This is because a risein inflation rate decreases the real interest rate and discourages the capital inflow.

Increase in Money Supply Price rise Lower real interest rate

Lower inflow of capital depreciation of domestic currency.

Q. Explain the Portfolio Balance Approach.

Ans. Introduction:- The portfolio balance approach suggests that it is not only themonetary factor but also the holding of financial assets such as domestic and foreign bondsthat influences the exchange rate. If foreign bonds and domestic bonds turn out to be perfectsubstitutes and if the conditions of interest arbitrage hold good, the portfolio balanceapproach will not be different from the monetary approach. But since these conditions do nothold good in real life, the portfolio balance approach maintains a distinction from themonetary approach.

This approach suggests that the exchange rate is determined by the interaction of following

factors:-

(i) Real Income

(ii) Interest Rates

(iii) Risk

(iv) Price Level

(v) Wealth

If a changes takes place in these variables, the investor re-establishes a desired balance inits portfolio. The re-establishment of the portfolio balance needs some adjustments which, inturn, influence the demand for foreign assets. Any such change influences the exchange

rate. For Example:-(1) A rise in real domestic income leads to a greater demand for foreign bonds. Demand

for foreign currency will rise, in turn, depreciating the domestic currency.


20/65

Domestic Income /Wealth Increase Greater demand for foreignfinancial assets depreciation of domestic currency.

(2) Again, the legal, political, and economic conditions in a foreign country may bedifferent from those at home. If foreign bonds turn out to be more risky on thesegrounds, the demand for foreign currency will decrease, in turn, appreciating the valueof domestic currency. Similarly, rising inflation in a foreign country makes foreignbonds risky. The demand for foreign currency will drop and the domestic currency willappreciate.

Foreign financial assets being more risky demand for themdecreases Appreciation of domestic currency.

When the exchange rate changes, the above mentioned variables change, whichcause a shift in the desired balance in the investment portfolio. Thus two -way forces

continue to act until equilibrium is reached, But the equilibrium is only short lived.Note: - It may be asserted that although real income, interest rate, risk and price level havean important role to play in exchange rate determination, the significance of wealth effect isquite large. When a country's wealth increases, holding of foreign assets increases.Demand for foreign currency goes up, which causes depreciation in the value of domesticcurrency.

Q. Write a short note on following:

(A) Fixed Exchange Rate System

(B) Flexible Exchange Rate System

Ans. Fixed Exchange Rate System:-Fixed exchange rates refer to the system under thegold standard where the rate of exchange tends to stabilize around the mint par value. Anylarge variation of the rate of exchange from the mint par value would entail flow of gold into orfrom the country. This would have the effect of bringing the exchange rate back to the mintpar value.

In the present day situation where gold standard no longer exists, fixed rates of exchangerefer to maintenance of external value of the currency at a predetermined level. Wheneverthe exchange rate differs from this level it is corrected through official intervention. Theremay be two situations:

1. When exports greater than imports: If the exports of the country exceed imports,the demand for the local currency in the exchange market will This will raise the value

of the currency to the market. Where the increase in value is beyond the support pointand central bank of the country intervenes in the market to sell local currency and thusthe foreign exchange reserves of the country increase. The sale of local currency inthe market leads to increase in money supply in the country causing inflation.Revaluation may be resorted to allow for more imports and contain inflation.


21/65

2. When imports greater than exports: If the country is facing balance of paymentsdeficits due to higher imports, it would have the effect of increase in supply of local

currency in the foreign and the central bank may have to intervene by buying localcurrency at a higher price. In the process, the foreign reserves of the country aredepicted because the foreign currencies are exchanges in the market for buying localcurrency. To make up for the deficit, the country may be compelled to devalue thecurrency. The large scale buying of local currency will reduce the domestic moneysupply and may help fight inflation.

Under fixed rates, the compulsion to devalue the currency may be postponed or avoided bymopping up additional reserves. One such way is exchange of currency reserves betweenthe central banks of countries.

1. When demand of foreign currency is greater than supply ( Demand > Supply)

When demand of foreign currency is more than supply, then central bank maintainsthe exchange rate by increasing the foreign currency in market. In this way supply offoreign currency will increases and there will be equality between demand & supply.

Excess Demand Sale of foreign Currency by Central Bank.

Results: In case of demand more than supply price of foreign currency in terms of domesticcurrency would be costly. Thus Central Bank supply foreign currency in market.

2. When Supply of foreign currency is greater than Demand ( Supply > Demand)

When Supply of foreign currency is more than demand, then central bank maintainsthe exchange rate by purchase of foreign currency or creates the demand of foreigncurrency in market through. In this way supply of foreign currency will decrease andthere will be equality between demand & Supply.

Y

D1

D

Rs./US $

S

D

D1

S

S1

S1


22/65

Excess supply Purchase of foreign currency by central bank .

Results : In case of supply more than demand price of foreign currency in terms ofdomestic currency would be cheaper. Central bank maintains the Foreign currency inmarket through.

Conclusion :

Demand > Supply ------------- Sale of foreign currency.

Supply > Demand ------------- purchase of foreign currency.

Criticisms

The main criticism of a fixed exchange rate is that flexible exchange rates serve to

automatically adjust the balance of trade. When a trade deficit occurs, there will beincreased demand for the foreign (rather than domestic) currency which will push up theprice of the foreign currency in terms of the domestic currency. That in turn makes the priceof foreign goods less attractive to the domestic market and thus pushes down the tradedeficit. Under fixed exchange rates, this automatic re-balancing does not occur.

(B) Floating Exchange Rate System:A floating exchange rate or fluctuating exchangerate is a type of exchange rate regime wherein a currency's value is allowed tofluctuate according to the foreign exchange market. A currency that uses a floatingexchange rate is known as a floating currency. It is not possible for a developingcountry to maintain the stability in the rate of exchange for its currency in the exchangemarket. Thus the central bank has to show or provide order line in the movement of

exchange rate. There are two situations:

1. Crawling Peg: In this situation central bank fix the upper limit & lower limit ofexchange rate. The exchange rate will lie between these two limits.

Y

D1

D

Rs./US $

S

D

D1

S

S1

S1


23/65

Upper Limit

Lower Limit

This can be explained with diagram:

2. Over shooting peg : Under this condition exchange rate can over the upperlimit and below the lower

(C) Hybrid Exchange Rate System :It is a combination of fixed and flexible exchangerate, this system hanges par values of currency by small amount at frequent specifiedintervals.

Unlike the earlier uniform system under either the gold standard or Breton Woods,today's exchange rate system fits into no tidy mold. Without anyone's is having

planned it, the world has moved to a hybrid exchange rate system. The major featuresare as follows:

1. A few countries allow their currencies to float freely, as the United States has forsome periods in the last two decades. In this approach country allows markets todetermine its currency's value and it rarely intervenes.


24/65

2. Some major countries have managed but flexible exchange rates. Today thisgroup includes Canada, Japan, and more recently Britain. Under this system a

country will buy or sell its currency to reduce the day-to-day volatility of currencyfluctuations.

3. Many countries particularly small ones change their currencies to a majorcurrency or to a basket of currencies.

4. Some countries join together in a currency bloc in order to stabilize exchangerates among themselves while allowing their currencies to move flexibly relativeto those of the rest of the world.

5. In addition almost all countries tend to intervene either when markets becomedisorderly or when exchange rates seem far out of line with the fundamentalsthat is with exchange rates that are appropriate for existing price levels andtrade flows

Q. Explain the Competitive Mint Par Theory.

Ans. Mint parity theory explains the determination of exchange rate between the twocountries which are a gold standard. In a country which is on gold standard, the currency iseither made of gold or is convertible into gold at a fixed rate. There are also no restrictions onthe export or import of gold.

The rate of exchange between the gold standard countries is determined on a weight toweight basis of the gold countries of their currencies. In other words, the exchange rate isdetermined by the gold equivalents of the currencies involved. The mint par is an expressionof the ratio of weights of gold's used for the coinage of the currencies. For examples beforeWorld War 1 England and American were on gold standard. The mint par between these twocountries was pound, one of England+4.866 dollars of America. The rate of exchange

showed that one pound of England contained as much fine gold as 4.866 dollars containedin America. The ratio of weights of metal1 pound= $4.866 was called the mint parity.

The mint par was a fixed rate. It remained so long as the monetary laws of the country remainunchanged. The current or the market rate of exchange, however, fluctuated from time totime due to changes in the balance of payments of the respective countries.

This theory is associated with the working of the international gold standard. Under thissystem, the currency in use was made of gold or was convertible into gold at a fixed rate. Thevalue of the currency unit was defined in terms of certain weight of gold, that is, so manygrains of gold to the rupee, the dollar, the pound, etc. The central bank of the country wasalways ready to buy and sell gold at the specified price. The rate at which the standardmoney of the country was convertible into gold was called the mint price of gold. If the official

British price of gold was 6 per ounce and of the US price of gold $ 36 per ounce, they werethe mint price of gold in the respective countries. The exchange rate between the dollar andthe pound would be fixed at $ 36/ 6 = $ 6. This rate was called the mint parity or mint par ofexchange because it was based on the mint price of gold. Thus under the gold standard, thenormal or basic rate of exchange was equal to the ratio of their mint par values (R=$/).


25/65

But the actual rate of exchange could vary above and below the mint parity by the costof shipping gold between the two countries. To illustrate this, suppose the US has a deficit in

its balance of payments with Britain. The difference between the value of imports andexports will have to be paid in gold by US importers because the demand for poundsexceeds the supply of pounds. But the transshipment of gold involves transportation costand other handling charges, insurance, etc. Suppose the shipping cost of gold from the USto Britain in 3 cents. So the US importers will have to spend $ 6.03 ($ 6 + .03c) for getting 1.This could be the exchange rate which is the US gold export point or upper specie point.The exchange rate under the gold standard is determined by the forces of demand andsupply between the gold points and is prevented from moving outside the gold points byshipment of gold

Figure shows the determination of the exchange rate under the gold standard. Theexchange rate OR is set up at point E where the demand and supply curves DD? and SS'

intersect. The exchange rate need not be at the mint parity. It can be anywhere between thegold points depending on the shape of the

Demand and supply curves. The mini parity is simply meant to define the us gold export point($6.03) and the us gold import point ($5.97)where the us beauty is prepared to sell

any amount of gold at the price of $36 per ounce, no American would pay more than $6.03per pound, because he can get any quantity of pounds at the price by exporting gold. That iswhy ,the us supply curve of pounds becomes perfectly elastic or horizontal at the us gold

export point. This is shown by horizontal portion S' of the SS' supply curve. Similarly, as theUS treasury is prepared to buy any quantity of gold at $36 per ounce, no American would sellpounds less than $ 5.97 because he can sell any quantity of pounds at that price by goldimports .Thus the US demand curve for pounds becomes perfectly elastic at the US goldimport point. This is shown by horizontal portion D' of the demand curve DD'.

Ex

changeRate

D Gold export point

S'

R

D'

Gold import point

S

Quantity of foreign exchange Pounds


26/65

The mint parity theory has long been discarded ever since the gold standard broke down.No country is on the gold standard. There are neither free movements of gold nor gold

parities. So this theory has only an academic interest.

Q. Write a short note on Overvalued and Undervalued Currencies.

Ans. Overvalued currency:Currency whose value is artificially higher than its marketvalue because of governmental support. A currency whose quoted or traded rate is abovewhat the market believes to be its correct level, given its country's balance of paymentsposition and other relevant factors. Traders and speculators would be reluctant to buy acurrency they believed to be overvalued as that suggests it should fall. If the domesticcurrency is considered overvalued, exporters would delay bringing in foreign-currencypayments, while importers would benefit from advancing payments.

Leads and lags: In international trade, the gaps between shipment and payment. Thesegaps can be exaggerated as importers and exporters try to advance or delay their paymentsor receipts according to how they expect exchange rates to move. If devaluation of thedomestic currency is forecast, importers with a foreign-currency obligation will hurry to pay(if they wait, they will need more local currency to pay the bill) - they 'lead' their payments.Exporters, on the other hand, would benefit in that situation by delaying converting foreigncurrency receipts into the local currency - they 'lag'. Before the virtual abolition of exchangecontrols in Australia in December 1983, leads and lags could not be exploited extensivelybecause, for example, exporters had to convert foreign receipts into $A within 30 days.Leads and lags are also used in a variety of economic models; for example, investment thisyear might be determined by last year's profits. Economists talk of the policy lag: in thiscontext the inside lag is the time taken to implement a policy change once the need for it isrecognised, and the outside lag is the time taken for the change to affect the economy onceimplemented.

Undervalued currency:A currency which is quoted or traded below what is perceived as itstrue market value, given its country's balance of payments position, economy, interest ratesand so on. An undervalued currency will be in demand as traders and speculators believe itwill rise and therefore will buy it to make a profit; enough of such buying and expectationsbecome self-fulfilling as demand pushes the currency higher. Exporters' and importers'views on currencies would influence how they manage cash flows. An exporter would bringforeign-exchange receipts into the country if the domestic currency were consideredundervalued and therefore likely to rise; an importer would delay payments in the hope thatthe undervalued domestic currency would rise, thereby reducing the cost of imports.

Q. Explain the Evolution of International Monetary System.

Ans. International Monetary System:International monetary system is defined as a set ofprocedures, mechanism, processes, and institutions to establish that rate at whichexchange rate is determined in respect to other currency. To understand the complexprocedure of international trading practice, it is pertinent to have a look at the historicalperspective of the financial and monetary system.


27/65

The whole story of monetary and financial system revolves around exchange rate i.e. therate at which currency is exchanged among different countries for settlement of payments

arising from trading of goods and services. To have an understanding of historicalperspectives of international monetary system, firstly one must have a knowledge ofexchange rate regimes. Various exchange rate regimes from 1880 to till date at theinternational level are described as follows:

(A) Monetary System before First World War (1880-1914 Era of Gold Standard): Theoldest system of exchange rate was known as "Gold Species Standard" in whichactual currency contained a fixed content of gold. The other version called "GoldBullion Standard", where the basis of money remained fixed gold but the authoritieswere ready to convert, at a fixed rate, the paper currency issued by them into papercurrency of another country which is operating in Gold. The exchange rate betweenpair of two currencies was determined by respective exchange rates against 'Gold'

which was called 'Mint Parity'. The main rules were followed with respect to thisconversion:

The authorities must fix some once-for-all conversion rate of paper moneyissued by them into gold.

There must be free flow of Gold between countries on Gold Standard.

The money supply should be tied with the amount of Gold reserves kept byauthorities.

The gold standard was very rigid and during great depression it vanished completely.

(B) The Gold Exchange Standard (1925-1931) :With the failure of gold standard duringfirst world war, a much refined form of exchange regime was initiated in 1925 in which

US and England could hold gold reserve and other nations could hold both gold anddollars as reserves. In 1931, England took its foot back which resulted in abolition ofthis regime.

(C) The Gold Exchange Standard ( 1925-1931) :With the failure of gold standard duringfirst world war, a much refined form of exchange regime was initiated in 1925 in whichUS and England could hold gold reserve and other nations could hold both gold anddollars as reserves. In 1931, England took its foot back which resulted in abolition ofthis regime.

(D) The Bretton Woods Era (1946 to 1971) : To streamline and revamp the war ravagedworld economy & monetary system allied powers held a conference in 'BrettonWoods', which gave birth to two super institutions:

(i) International Monetary Fund (IMF)

(ii) World Bank (WB)

In Bretton Woods modified form of Gold Exchange Standard was set up with thefollowing characteristics:


28/65

(i) One US dollar conversion rate was fixed by the USA as one dollar = 35 ounce ofGold.

(ii) Other member agreed to fix the parities of their currencies vis--vis dollar withrespect to permissible central parity with one per cent fluctuation on either side.In case of crossing the limits, the authorities were free hand to intervene to bringback the exchange rate within limits.

Mechanism of Bretton Woods:The mechanism of Bretton Woods can be understood withthe help of the following illustration and diagram:

Suppose there is a supply curve SS and demand curve DD for dollars. On OY-axis price ofdollar with respect of rupees are shown. Suppose Indian residents start demanding

American goods & services. Naturally demand of US Dollar will rise. And suppose USresidents develop an interest in buying goods and services from India, it will increase supplyof dollars from America.

Assume a parity rate of exchange is Rs. 10.00 per dollar. The +1% limits are therefore Rs.10.10 (Upper Support) and Rs. 9.90 (Lower Support).

As long as the demand and supply curve intersect within the permissible rant; Indian

authorities will not intervene.Suppose demand curve shifts towards right due to a shift in preference of Indian towardsbuying American goods and the market determined exchange rate would fall outside theband, in this situation, Indian authorities will intervene and buy rupees and supply dollars tobring back the demand curve within permissible band. The vice-versa can also happen.

D1D

S

Rs./$

10.10Upper SupportParity

10.00

9.90 Lower Support

Quantity of Dollars

D1

D

S


29/65

During Bretton Woods regime American dollar became international money while othercountries needed to hold dollar reserves. US could buy goods and services from her own

money. The confidence of countries in US dollars started shaking in 1960s withchronological events which were political and economic and on August 15, 1971 Americanabandoned their commitment to convert dollars into gold at fixed price of $35 per ounce, thecurrencies went on float rather than fixed. Though "Smithsonian Agreement".

(E) Current Scenario of Exchange Rate Regime:At present IMF categories differentexchange rate mechanism as follows:

(i) Currency Board Agreement: In this regime, there is a legislative commitmentto exchange domestic currency against a specified at a fixed rate. As of 1999,eight members had adopted this regime.

(ii) Conventional Fixed peg arrangement: This regime is equivalent to BrettonWoods in the sense that a country pegs its currency to another or to a basket ofcurrencies with a band variation not exceeding + 1% around the central parity.Upto 1999, thirty countries had pegged their currencies to a single currencywhile fourteen countries to a basket of currencies.

(iii) Pegged Exchange Rates within Horizontal Bands: In this regime, thevariation around a central parity is permitted within a wider band, it is a middleway between a fixed peg and floating peg. Upto 1999, eight countries had thisregime.

(iv) Crawling Peg: Here also a currency is pegged to another currency or a basketof currencies but the peg is adjusted periodically which may be pre-announcedor discretion based or well specified criterion. Sixty countries had this type ofregime in 1999.

(v) Crawling Bands: The currency is maintained within a certain margin around acentral parity which crawls in response to certain indicators. Upto 1999, ninecountries enjoyed this regime.

(vi) Managed Float: In this regime, central bank interferes in the foreign exchangemarket by buying and selling foreign currencies against home currencieswithout any commitment. Twenty five countries have this regime as in 1999.

(vii) Independent floating: Here exchange rate is determined by market forces andcentral bank only act as a catalyst to prevent excessive supply of foreignexchange and not to drive it to a particular level. Including India, in 1999, fortyeight countries had this regime.


30/65

UNIT II


Q. What are the major factors influencing the Exchange Rate?

Ans. Factors Influencing Exchange Rate:-The most important factor influencing theexchange rate are:-

1. Balance of Payments:-Balance of Payments position of a country is a definiteindicator of the demand and supply of foreign exchange. There are two situations:-

(i) If a country is having a favourable balance of payments position it implies thatthere is more supply of foreign exchange and therefore foreign currencies willtend to be cheaper.

(ii) If balance of payments position is unfavourable, it indicates that there is moredemand for foreign exchange and this will result in the price of foreign currency.

2. Strength of the Economy :- The relative strength of the economy also has an effecton the demand and supply of foreign currencies. If an economy is growing at a faster

rate it is generally expected to have a better performance on balance of trade.

3. Fiscal Policy:- The fiscal policy followed by government has an impact on theeconomy of the country which in turn affects the exchange rates. If the governmentfollows an expansionary policy by having low interest rates, it will fuel the engine ofeconomic growth and as discussed earlier, it will lead to better trade performance.

4. Monetary Policy:- The monetary policy is a very effective toll for controlling moneysupply, and is used particularly for keeping a tab on the inflationary pressures in theeconomy. The main objective of the monetary policy of any economy is to maintain themoney supply in the economy at a level which will ensure price stability, fullemployment and growth in the economy. If the money supply in the economy is more itwill lead to inflation and the central bank will raise interest rates, sell government

securities through open market operations, raise cash reserve requirement and vice-versa.

It will be clear from the above discussion that monetary policy influences interest rates,inflation, employment etc. and consequently affects the exchange rates.


31/65

5. Interest Rate:- High interest rates make the speculative capital move betweencountries and this affects the exchange rate. If interest rates of domestic currency are

raised this will result in more demand for domestic currency and more supply of theforeign currency, thus making the latter cheaper.

6. Political Factors:- If a change is expected in the government on account of elections ,the exchange rates may be affected. However, whether the currency of the countryconcerned will become stronger or weaker will depend upon expected policies to bepursued by the new government which is likely to take over. War also affects theexchange rates of the currencies of the country involved. Some times it affects thecurrencies of other countries also.

7. Exchange Control:- Exchange control is generally aimed at disallowing freemovement of capital flows and it therefore affects the exchange rates. Sometimescountries exercise control through exchange rate mechanism by keeping the price of

their currency at an artificial level.8. Central Bank Intervention:-Buying or selling of foreign currency in the market by the

central bank with a view to increase the supply or demand, thereby affecting theexchange rate is known as 'Intervention'. If a central bank is of the opinion that localcurrency is becoming stronger thereby affecting the exports, it will buy foreigncurrency and sell local currency. It will increase the demand for foreign currency andthe rates of foreign currency.

The central banks all over the world also play a crucial role in maintaining an orderlyforeign exchange market. Thus at the time of violent fluctuations in the exchange ratesthe central banks intervene in the market.

9. Speculation:- In the foreign exchange market dealers taking speculative positions is

common. If a few big speculative operators are buying a particular currency in a bigway others may follow suit and that currency may strength in the short run. This ispopularly known as the 'Bandwagon affect' and this affects exchange rates.

10. Tariff and Non-tariff Barriers:- Imports are restricted through tariff and Non-tariffbarriers . Tariff means duty levied by the government on imports. When assessed on aper unit basis, tariff is known as specific duty. But when assessed as a percentage ofthe value of the imported commodity, tariff is called ad valorem duty. When both typesof tariff are charged on the same product, it is known as compound duty. Apart fromtariff, import is restricted through non-tariff barriers.

Q. Explain Central Bank Interventions for Exchange Rate Stability.

Ans. Central Bank Intervention:-Buying or selling of foreign currency in the market by thecentral bank with a view to increase the supply or demand, thereby affecting the exchangerate is known as 'Intervention'. If a central bank is of the opinion that local currency isbecoming stronger thereby affecting the exports, it will buy foreign currency and sell localcurrency. It will increase the demand for foreign currency and the rates of foreign currency.


32/65

The central banks all over the world also play a crucial role in maintaining an orderly foreignexchange market. Thus at the time of violent fluctuations in the exchange rates the central

banks intervene in the market.

CENTRAL BANK INTERVENTION FOR EXCHANGE RATE STAIBILITY

Central bank has been charged with the responsibility of maintaining external value of thecurrency of the country and also maintains a stable exchange rate.

TWO FUNCTIONAL ASPECTS OF CENTRAL BANK

CONTROL ON FLOATING/ FIXED

DEMAND/ SUPPLY EXCHANGE RATEOF FOREIGN CURRENCY

(A) Central Bank Intervention with Fixed Exchange Rates:

In a fixed exchange rate system most of the transactions of one currency for another will takeplace in the private market between individuals, businesses and international banks.However, by fixing the exchange rate the government would have declared illegal anytransactions that do not occur at the announced rate. However, it is very unlikely that theannounced fixed exchange rate will at all times equalize private demand for foreign currencywith private supply. In a floating exchange rate system, the exchange rate adjusts tomaintain the supply and demand balance. In a fixed exchange rate system it becomes theresponsibility of the central bank to maintain this balance.

The central bank can intervene in the private FOREX market whenever needed by acting asa buyer and seller of currency of last resort. To see how this works, consider the followingexample.

E$

E$

D

Q1 Q2 Q

D

S

S'


33/65

Suppose the US establishes a fixed exchange rate to the British pound at the rate ?$/. Inthe adjoining figure we depict an initial private market FOREX equilibrium in which the

supply of pounds (S) equals demand (D) at the fixed exchange rate ?$/. But suppose, forsome unspecified reason, the demand for pounds on the private FOREX rises one day toD'. At the fixed exchange rate, ?$/, private market demand for pounds is now Q2 whereassupply of pounds is Q1. This means there is excess demand for pounds in exchange for USdollars on the private FOREX.

To maintain a credible fixed exchange rate, the US central bank would immediately satisfythe excess demand by supplying additional pounds to the FOREX market. That is, they sellpounds and buy dollars on the private FOREX. This would cause a shift of the pound supplycurve from S to S'. In this way the equilibrium exchange rate is automatically maintainedat the fixed level.

Alternatively, consider the next diagram in which again the supply of pounds (S) equals

demand (D) at the fixed exchange rate ?$/. Now suppose, for some unspecified reason,the demand for pounds on the private FOREX falls one day to D'. At the fixed exchangerate, ?$/, private market demand for pounds is now Q2 whereas supply of pounds is Q1.This means there is excess supply of pounds in exchange for US dollars on the privateFOREX.

In this case, an excess supply of pounds also means an excess demand for dollars inexchange for pounds. The US central bank can satisfy the extra dollar demand by enteringthe FOREX and selling dollars in exchange for pounds. This means they are supplying moredollars and demanding more pounds. This would cause a shift of the pound demand curvefrom D'back to D. Since this intervention occurs immediately, the equilibrium exchangerate is automatically and always maintained at the fixed level.

E$

E$

D

Q1 Q2 Q

D

S'


34/65

(B) Floating Exchange Rate System:-

In a floating-rate system, it is the market forces that determine the exchange rate betweentwo currencies. In floating exchange Rate system the central bank does not control demandor supply of foreign currency. Thus the central bank has to show or provide order line in themovement of exchange rate. There are two situations:

a) Crawling Peg: In this situation central bank fix the upper limit & lower limit ofexchange rate. The exchange rate will lie between these two limits.

Upper Limit

Lower Limit

This can be explained with diagram:

b) Over shooting peg : Under this condition exchange rate can over the upperlimit and below the lower

Q. Explain DORNBUSCH Sticky-Price theory of Exchange Rate Volatility.

Ans. DORNBUSCH Sticky-Price theory:-The sticky price version makes a more detailedstudy of interest rate differential. The argument in favour of this approach is that an increasein money supply (through changes in the real interest rate differential) leads to depreciationin the value of domestic currency.


35/65

Assumptions:-

The monetary approach of the sticky price version rests on a couple of assumptions.(i) Money Supply is Endogenous:-The money supply in a country is endogenous,

meaning that it is positively related to the market interest rate.

(ii) PPP Theory applies in long run:-The second assumption is that the PPP theoryapplies in the long run and so the expected inflation differential changes have a role toplay in the determination of the exchange rate.

Explanation:-The sticky price theory can be explained in two sections:-

(A) Study of Interest Rate Differential:-The sticky price version makes a detailed studyof interest rate differential. The interest rate differential has three components:-

(2) One denotes that when the interest rate rises, the money balances held by the public

come to the money market in lure of high interest rate. Money supply increasesleading to currency depreciation.

Increase in Money Supply Depreciation of domestic currency.

(3) Second denotes that if interest rate rises, financial institutions increase the funds to besupplied to the money market. Money supply increases and the value of domesticcurrency depreciates.

Rise in Interest Rate Increase in money supply (loanable funds)Depreciation of domestic currency.

(4) The third is that a rise in interest rate stimulates the capital inflow into the country that,like the balance of payments approach, causes appreciation in the value of domesticcurrency.

Rise in Interest Rate Greater inflow of capitalAppreciation of domestic currency.

(B) Study of Inflation Rate Differential:- The sticky price version specially mentions theexpected inflation rate differential. A rise in inflation rate compared to that in the foreigncountry leads to depreciation in the value of domestic currency. This is because a risein inflation rate decreases the real interest rate and discourages the capital inflow.

Increase in Money Supply Price rise Lower real interestrate Lower inflow of capital depreciation of domesticcurrency.

Q. Explain J-Curve Effect OR Effect of Devaluation on Trade Balance.

Ans. J-Curve Effect:- In economic terms, balance of payments equilibrium occurs whensurplus or deficit is eliminated from the balance of payments. However, normally, in real life,


36/65

Currency Depreciation

Trade balance eventually improves

Trade balance initially deteriorates

such equilibrium is not found. Rather it is the disequilibrium in the balance of payments thatis a normal phenomenon.

There are external economic variables influencing the balance of payments and giving riseto disequilibrium. But domestic economic variables are more important for causingdisequilibrium.

The adjustment in the balance of payments disequilibrium was thought of in terms ofchanges in the fixed exchange rate, that is through devaluation or upward revaluation. Butits success dependent upon the elasticity of demand for export and import. Marshall andLerner explained this phenomenon through the 'elasticity' approach.

Elasticity Approach:- The elasticity approach is based on partial equilibrium analysiswhere everything is held constant, except for the effects of exchange rate changes on exportor import. There are some other assumptions:-

(i) The elasticity of supply of output is infinite so that the price of export in home currencydoes not rise as demand increases.

(ii) Elasticity approach ignores the monetary affects of variation in exchange rates.

Based on these assumptions, devaluation helps improve the current balance only if:

Em + Ex > 1

Em = Price Elasticity of demand for import.

Ex = Price Elasticity of demand for export.

If the elasticity of demand is greater than unitary, the import bill will contract and export

earnings will increase. Trade deficit will be removed. When the devaluation ofcurrency leads to a fall in export earnings in the initial stage and then a rise in exportearnings, making the earning curve look like the alphabet, J it is called J-curve effect.

J-curve can be explained with the help of following diagram:-


37/65

Explanation: -

In this figure time is shown on OX- axis and Balance of trade is shown on OY-axis. Tradebalance moves deeper into the deficit zone immediately after devaluation. But then itgradually improves and crosses into surplus zone. The curve resembles the alphabet, J andso, it is known as the J-curve Effect.

Criticism:- The weakness of the elasticity approach is that it is a partial equilibrium analysisand does not consider the supply and cost changes as a result of devaluation as well as theincome and the expenditure effects of exchange rate changes. In this context, it may bementioned that it was Stern (1973) who incorporated the concept of supply elasticity in theelasticity approach. According to him, devaluation could improve balance of payments onlywhen:

Where X = Exports M = Imports.

EDx = Elasticity of demand for exports

ESx = Elasticity of supply for exports

EDm = Elasticity of demand for imports

ESm= Elasticity of supply for imports.


38/65

UNIT III


Q. Define Foreign Exchange Market. Explain its Nature.

Ans. Foreign Exchange Market:-The foreign exchange market is the market where thecurrency of one country is exchanged for that of another country and where the rate ofexchange is determined. The genesis Foreign Exchange (FE) market can be traced to theneed for foreign currencies arising from:

International Trade.

Foreign Investment.

Lending to and borrowing from foreigners.

In order to maintain the equilibrium in the FE market, the monetary authority of theconcerned country normally intervenes/steps in to bring out the desired balance by:

Variation in the exchange rate

Changes in official reserves

Both.

Every firm operating in international environment faces problems with foreign exchange i.e.,the exchange of foreign currency into domestic and vice-versa. Generally firm's foreignoperations earn income denominated in some foreign currency, however shareholdersexpect payment in domestic currency and therefore the firm must convert foreign currencyinto domestic currency.

Definition of Foreign Exchange Market:-

According to Foreign Exchange Regulation Act

"Foreign Exchange means foreign currency and includes:

(a) (i) All deposits, credits and balances payable in any foreign currency.

(ii) The drafts, traveler's cheques, letters of credits and bills of exchange expressedor drawn in Indian currency but payable in any foreign currency.


39/65

(b) All instruments payable at the option of the drawee or the holders thereof or any otherparty there to either in Indian currency or in foreign currency partly in one and partly in

other.

This is clear from the above definition that the foreign exchange market is the market whereforeign currencies are bought and sold. In other words foreign exchange market is a systemfacilitating mechanism through which one country's currencies can be exchanged for thecurrencies of another country.

Nature or Features of Foreign Exchange Market:-

1. Global Market:- Foreign exchange market is a global market. It means foreignexchange buyer and seller world wide exist. It is the largest market in the world.

2. Over the Counter Market:- In has already been mentioned that different currenciesare bought and sold in the foreign exchange market. The market does not denote a

particular place where currencies are transacted. Rather it is an over the countermarket. It consists of trading desks at major agencies dealing in foreign exchangethroughout the world, which are connected by telephones, telex and so on.

3. Around the Clock Market:- Foreign exchange market is a round the clock marketmeaning that the transactions can take place any time within 24 hours of the day. Themarkets are situated throughout the different time zones of the globe in such a waythat one market is closing the other is beginning its operations. Thus at any point oftime one market or the other is open..

4. Currencies Traded:- In the foreign exchange market one country's currencies can beexchanged for the currencies of another country. In this market only currencies aretraded.

5. 1-2% transactions are for actual trade, rest for speculation:- In foreign exchangemarket only 1-2% transaction are for actual trade and most of the transaction is relatedto speculation.

6. System:- Foreign exchange market is a system. It is a system of private banks,financial banks, foreign exchange dealers and central bank through which individual,business and government trade foreign exchange.

7. No physical transfer of money:- In foreign exchange market, most markets have anelectronic system for transfer of funds, which save time and energy.

8. Exist in the network of information system:- It is more informal arrangementamong the banks and brokers operating in a financial centre purchasing and sellingcurrencies, connected to each other by Tele-communication like telex, telephone etc.

9. Banks are involved in 95% cases:- Most of the transactions in foreign exchangemarket is done with the help of commercial banks.

10. Foreign exchange market facilitates trade and investment.


40/65

11. A party can never be a demander of one currency without being simultaneously asupplier of another.

Functions of Foreign Exchange Market:-

1. Transfer of Purchasing Power:- Transfer of purchasing power is necessaryinternational trade and capital transactions normally parties living in countries withdifferent national currencies. Each party usually wants to deal in its own currency, butthe trade or capital transactions can be invoiced in one single currency. The foreignmarket provides the mechanism for carrying out these purchasing power transfers.

2. Provision of Credit:- Because the movement of goods between countries takes time,inventory in transit must be financed.

3. Minimizing Foreign Exchange Risk:-Each may prefer to earn a normal businessprofit without exposure to an unexpected change in anticipated profit because

exchange rates suddenly changes. The foreign exchange market provides "hedging"facilities for transferring foreign exchange risk to someone else.

Q. Who are the Participants in the Foreign Exchange Market? Also Explain theStructure of Foreign Exchange Markets.

Ans. Foreign Exchange Market:-The foreign exchange market is the market where thecurrency of one country is exchanged for that of another country and where the rate ofexchange is determined.

Major Participants of Foreign Exchange Market:- Foreign exchange market is a world widemarket and is made up of:

1. Retail Clients :- Retail clients made up of:

Tourists:- Individuals are normally tourists who exchange their currencies.They also migrants sending a part of their income to their family members livingin their home country.

Firms:-Firms that participate are generally importers or exporters. Exportersprefer to get the payments in their own currency. Importers need foreignexchange for making payments for the import.

International Investors

Multinational Corporations

Any other who need foreign exchange.

2. Commercial Banks Or Local Banks:-When firms and individual approach the localbranch of a bank, the local branch, in turn, approaches the foreign exchangedepartment in its regional office or head office. The later deals in foreign exchange withother banks on behalf of the customers. Thus, there are two tiers in the foreignexchange market.


41/65

(i) One tier involves the transactions between the ultimate customers and thebanks.

(ii) The other tier consists of transactions between tow banks. The purpose of inter-bank transactions is not only to meet the foreign exchange demand of theultimate customers, but also to reap gains out of movement in foreign exchangerates. In some cases, inter-bank dealings take place directly, without any helpfrom intermediaries, but generally banks operate through foreign exchangebrokers.

3. Central Banks:- These banks have been charged with the responsibility ofmaintaining external value of the currency of the country. Two functional aspects doneby Central Bank:

TWO FUNCTIONAL ASPECTS OF CENTRAL BANK:

Control on Demand/ Fixed/Floating Exchange Rate

Supply of Foreign currency

4. Speculators:-Speculators who buy or sell currencies when they expect movement inthe exchange rate in a particular direction. The movement of exchange rate in thedesired direction gives them profit.

5. Arbitrageurs: -Arbitrageurs who exchange currencies because of varying rates ofexchange in different markets. The varying rates are the source of their profit. Theybuy a particular currency at a cheaper rate in one market and sell it at a higher rate inthe other. This process is known as currency arbitrage.

6. Hedgers:- Non-banking entities, such as traders, that use the foreign exchangemarket for the purpose of hedging their foreign exchange exposure on account ofchanges in the exchange rate. They are known as hedgers.


42/65

Structure of Foreign Exchange Markets:

Q. Define Spot and Forward Markets.

Ans. Introduction:The foreign exchange market is classified either as a spot market or asa forward market. It is the timing of the actual delivery of foreign exchange that differentiatesbetween spot market and forward market transactions. The spot and forward markets are:-

(1) Spot Market:-In the spot market ,currencies are traded for immediate delivery at therate existing on the day of transaction. For making book-keeping entries, deliverytakes two working days after the transaction is complete. If a particular market isclosed on Saturday and Sunday and of transaction takes place on Thursday, deliveryof currency shall taken place on Monday. Monday, in this case, is known as the valuedate or settlement date. Some times there are short-date contracts where tome zonespermit the delivery of the currency even earlier. If the currency is delivered the sameday, it is known as the value-same-day contract. If it is done next day, the contract isknown as the value next-day contract.

RETAIL CLIENTS

LOCAL BANK

FOREIGN

EXCHANGEBROKER

MAJOR BANKSINTER BANK

FOREIGN

EXCHANGEBROKER

LOCAL BANK

RETAIL CLIENTS


43/65

The exchange rate for immediate delivery is called spot exchange rate and is denotedby S (.)

For Example :- S(Rs./$) = Rs. 36.10/$

Forward Market:- In the forward market, on the contrary, contracts are made to butand sell currencies for a future delivery, say, after a fortnight, one month, two months,and so on. The rate of exchange for the transaction is agreed upon on the very day thedeal is finalized. In other words, no party can back out of the deal even if changes in thefuture spot rate are not in his/her favour. The exchange rate for delivery and paymentat specified future dates are called forward exchange rates and is denoted by F (.). Themajor participants in forward market can be categorized:-

Arbitrageurs

Hedgers

Speculators

The maturity period of a forward contract is normally one month, two months, threemonths, and so on. But sometimes it is not for the whole month and represents afraction of a month. A forward contract with a maturity period of 35 days is an example.Naturally, in this case, the value date falls on a date between two whole months. Sucha contract is known as broken-date contract.

Example of Spot And Forward Market:- Suppose a currency is purchased on the 1st ofAugust; if it is a spot transaction, the currency will be delivered on the 3rd of August, but if it isa one-month forward contract, the value date will fall on the 3rd of September. If the valuefalls on a holiday, the subsequent date will be the value date. If the value date does not exist

in the calendar, such as the 29th February (if it is not a leap year), the value date will fall onthe 28th of February.

Q. Write a short note on Forward Premium

Ans. Forward Rates:-The quotes for the forward market are also publish in thenewspapers. There are two ways of quoting forward rates:-

(i) Outright Quote:-The outright quote for the US dollar in terms of the rupee can bewritten for different periods of forward contract, as follows

Spot One month Three months

(ii) Swap Quote:- The swap quote, on the other hand, expresses only the differencebetween spot quote and forward quote. Decimals are not written in swap quotes.

Forward Premium:- If the forward rate is higher than the spot rate, it would be knownas the forward premium. Forward premium is expressed as an annualized percentagedeviation from the spot rate. It is computed as follows:-


44/65

FORWARD RATE - SPOT RATE 360FORWARD PREMIUM (DISCOUNT) = X

SPOT RATE N

40-39.80 360Forward Premium =--------------- X ------------ = .0603 Or 6.03 %

39.80 30

Q. What are the methods of Quoting Exchange Rates?

Ans. Meaning of Quotation:-Quotation is amount of a currency necessary to buy or sell aunit of another currency. There are various methods of quoting exchange rates:-

(B) Direct and Indirect Quotes

(C) Bid and Ask Rates

(D) American and European Terms Quotes.(E) Forward Rates

(F) Cross Rates

(B) Direct and Indirect Quotes:- Exchange rates are quoted either directly or indirectly:

(i) Direct Quote:- A direct quotes gives the home currency price of a certainquantity of foreign currency, usually one unit. In other worlds price of one unit offoreign currency quoted in terms of home country's currency is known as directquote. If India quotes the exchange rate between the rupee and US dollardirectly, the quotation will be written as

Rs. 45/US$.

(ii) Indirect Quotes:- In case of indirect quoting, the value of one unit of homecurrency is presented in term of foreign currency. In other worlds price of oneunit of home currency quoted in terms of foreign currency is known as indirectquote. If India adopts indirect quote, the banks in India will quote the exchangerate as

US$0.022/Re.

(C) Bid and Ask Rates OR Buying and Selling Rates:- In interbank market, banksquote two way price:-

Bid-Price:- The rate at which the bank is willing to buy the currency from you isbid price.

BID = Bank Buy

Ask-Price :- The rate at which the bank is willing to sell the currency to you is theask price.

ASK= Bank Sell


45/65

Bid-Ask Spread:- When a bank quotes for a currency it simultaneously offers anothercurrency in lieu, i.e. if it buy dollars for rupees, it is simultaneously offering rupees for

dollars. The bid-ask spread is the spread between bid and ask rates for a currency. Inother words, Ask and Bid differential is called the spread.

SPREAD = ASK PRICE - BID PRICE

Differen

Foreign Exchange Management (3)

Documents