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B.N. Ghosh

Business Environment

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Chapter 30

Exchange Rate Environment

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Learning Objectives• The meaning of exchange rate• The determination of equilibrium exchange rate• Theories of foreign exchange rate• The causes of fluctuations in exchange rates• The differences between fixed and flexible exchange rates• The features, objectives, merits, demerits, and methods of exchange control• The different exchange rate practices• The concepts of forward exchange market, nominal and real exchange rates, and Euro currency

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Meaning of exchange rate• The rate at which the currency of one country is exchanged for the currency of another countryis called the rate of foreign exchange.

• It should be noted that exchange rate is not always constant.

• It goes on changing from time to time on account of changes in the demand of and the supply of foreigncurrency.

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Determination of equilibrium exchange rate

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Determination of equilibrium exchange rate

• Just as the price of a commodity is determined by its demand and supply in the market, similarly, the price of a currency is also determined by the demand for andthe supply of that currency in the foreign exchange market.• The supply of dollars in the foreign exchange market will come from the exporters who have sold their commodities in the USA.

• It is instructive to note that fluctuations in the domesticexchange rate and its continuous fall ultimately may lead to currency crisis (or financial crisis).

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Theories of foreign exchange rate

• Mint Par Theory

• Purchasing Power Parity Theory

• Balance of Payments Theory of Exchange Rate

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Balance of payments theory of exchange rate determination

• The demand for a foreign currency arises out of the necessity of purchasing foreign goods, or making payment to foreign countries or making investment, or for repayment of debts.

• When the balance of payments is unfavourable, the country will have a weak exchange rate position, but the exchange rate position will be strong if the country has afavourable balance of payments.

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Causes of fluctuations in exchange rate

• Political instability produces lack of confidence not only for a country but also for its currency. Loss of confidence in a particular currency results in the transfer of money from that country to some other country.

• Whenever a country is entitled to receive money on current account, the demand for its currency increases and the external value of the currency (exchange rate) goes up. In the opposite case, when the country has a debit balance in the current account, its exchange rate will fall.

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Fixed vs flexible exchange rates

• Both these exchange rates have their merits and demerits.

• The best method will be to have a system that permits a country to have a rate of exchange that is not fully fixed but can be changed within certain well-defined limits.

• This means that the requirement should be a system of flexible exchange stability of the type provided by the IMF.

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Exchange control• Under this system, the government and the central bank keep the exchange rate fixed at aparticular point of time.

• They control the forex market and no transaction involving an exchange can be settled without the permission of the government⁄central bank.

• Exchange control system was adopted by most of the countries after the World War II.

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Features of Exchange Control• There is complete control over the use of forex.• Imports are regulated.• The exporters have to surrender their forex to the monetary authority.• The government determines the rate of exchange. The rate of exchange is not flexible.• Forex can be used only by the license holders.• Forex is allocated by the government or central bank in priority lines.• Some types of transactions are not permitted.• Directions are given for the use of forex.• The value of each type of foreign transactions is regulated.

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Exchange rate practices

• Adjustable Peg

• Crawling Peg

• Managed Floating

• Arbitrage Operations

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Forward exchange market• A forward exchange market is one where contracts are made to supply currencies at fixed dates in the future at fixed prices.

• In the forward exchange market, currencies are bought and sold for transacting at some future date.

• The forward exchange market is a part of overall forexmarket.

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Forward exchange market• Forward exchange market has two parts: (i) Spot market and (ii) Forward market.

• In the spot market, forex are purchased and sold on the spot at the prevailing market rate.

• The forward market or the future exchange market refers to the market where agreements are made to supply foreign currency at some future date at a price agreed now.

• The rate at which forward exchanges are made is called forward rate of exchange .

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Nominal and real exchange rates

• The nominal exchange rate (NER) is the exchange rate between two currencies.• •RER = NER X

• This rate is not relevant in the exchange of goods and services between two countries (Mankiew 2008 ).

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The Mundell-Fleming Model• The Mundell–Fleming model introduced by Robert Mendel and Marcus Fleming (Sills and Merton 1991 ) became popular in the 1960s to explain fluctuations in income, and the workhorse is still being used for decision-making. Basically, the model is an extension of the conventional IS–LM (fiscal–monetary) framework.

• The model states that it is practically impossible for a country to have a fixed exchange rate regime, full capital mobility, and an independent monetary policy at the same time. This is popularly known as Impossible Trinity or Mundell Trilemma .

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Euro currency• Euro currency is any currency that is deposited by a company, government, or individuals in banks outside the domestic economy.

• Generally, there are four major currencies that are being increasingly used as Euro currency.

• These are American dollars, the British pound sterling, Euro zone euro, and the Japanese yen.

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Demerits of Euro Markets• As there is no government guarantee, these markets are less secure for the depositors. There is nothing like deposit insurance. However, the markets are working well, and so far, no major untoward incident has been reported internationally.

• These markets are exposed to forex risks as compared to domestic institutions. This is so because these markets have no linkages with the domestic currency.

• In the absence of government control and strict laws, it is difficult to settle the legal issues or disputes between the borrower and the lender.