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Foreign exchange market
International trade
Chapter -7
Lecture- 6
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Determination of exchange rates
Meaning of foreign exchange rate
It is the price of one currency in terms of others. It
is the rate at which exports and imports of a nation
are valued at a given point in time.
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Foreign exchange market
It is the market where the national currencies are
traded for one another. It performs mainly three
functions:1. To transfer the purchasing power between
countries.
2. To provide credit channels for foreign trade.3. To protect against foreign exchange rate.
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Foreign exchange market
Who needs foreign exchange market?
When people wish to operate in the foreign
exchange market they intend to buy or sell foreign
exchange depending on their demand for and
supply of foreign exchange.
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Foreign exchange market
Demand side
People desire to have or acquire foreign exchange
for the following reasons:1. To purchase goods and services from other
countries.
2. To send a gift aboard or make a visit aboard.3. To purchase financial assets in a particular
country
4. To speculate on the value of foreign currencies.
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Foreign exchange market
Supply side
Foreign currencies flow into the domestic
economy due to the following:1. Foreigners purchasing home ,countries goods
and services through export.
2. Joint venture or through financial marketoperations.
3. Currency dealers and speculators.
4. Visiting domestic territory and sending gift.
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Determination theory
exchange rate movements affect a nation's trading
relationships with other nations.
A higher currency makes a country's exports more
expensive and imports cheaper in foreign markets;
a lower currency makes a country's exports cheaper
and its imports more expensive in foreign markets.
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Purchasing power parity (PPP)
1.Purchasing power parity(PPP) is an economic theory
and a technique used to determine the relative value of
currencies estimating the amount of adjustment needed on
the exchange rate between countries in order for theexchange to be equivalent to (or on par with) each
currency's purchasing power.
It asks how much money would be needed to purchase the
same goods and services in two countries, and uses that to
calculate an implicit foreign exchange rate. Using that PPP
rate, an amount of money thus has the same purchasing
power in different countries.
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Purchasing power parity (PPP)
The relative version of PPP is calculated as:
S= P1/P2
Where:"S" represents exchange rate of currency 1 to
currency 2
"P1" represents the cost of good "x" incurrency 1
"P2" represents the cost of good "x" in
currency 2
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Interest rates
2. The international Fisher effect is a hypothesisin international finance that suggests differences in nominal
interest rates reflect expected changes in the spot exchange
rate between countries.
The hypothesis specifically states that a spot exchange rate
is expected to change equally in the opposite direction of
the interest rate differential; thus, the currency of the
country with the higher nominal interest rate is expected todepreciate against the currency of the country with the
lower nominal interest rate, as higher nominal interest rates
reflect an expectation of inflation
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Interest rates
The Fisher equation is
r= R-I
This means, the real interest rate (r) equalsthe nominal interest rate (R) minusexpected inflation rate(I)
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Interest rates
The nominal interest rate is the interest rate you hearabout at your bank. If you have a savings account for
instance, the nominal interest rate tells you how fast the
number of dollars in your account will rise over time. The
real interest rate corrects the nominal interest rate for the
effect of inflation in order to tell you how fast
the purchasing power of your savings account will rise
over time.
Real interest rate = Nominal Interest Rate - Expected
Inflation Rate Nominal Interest Rate = Real interest Rate
+ Expected Inflation Rate
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Other considerations
3. Confidence in the currency-saving tendency by
customer.
4. Technical factors- seasonal demand for currency, the
slight strengthening of a currency followed by a
prolonged weakness etc.
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Exchange control methods
Meaning of exchange control methods: exchange control
refers to a governments inter in the foreign exchange
market. In other words, it means legal restrictions on the
business involving foreign exchange and its sale and
purchase in the national market. It is government
domination in the foreign exchange market.
In the words of Haberler, Exchange control is the state
regulation excluding the free play of economic forces
from the free play of foreign exchange marketSumming
up, exchange control is a, method of influencing
international trade, investment and the payments
mechanism.
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Unilateral Methods
(A)Unilateral methods are those methods of exchange
control which are adopted by the government of a
country without any consultation or understanding
with any other country. The main methods under thishead are as follows:
1. Exchange pegging.
2. Exchange Equalization Account.
3. Clearing Agreement
4. Stand still Agreement.
5. Compensation Agreement.
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Unilateral Methods
6. Blocked Accounts.
7. Payment Agreements.
8. Rationing of Foreign exchange
9. Multiple Exchange Rates
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Bilateral or Multilateral Methods
(B) Bilateral or Multilateral Methods.
When two or more than two countries decide to adopt
certain measures for stabilizing the rates of exchange
between them, these are called bilateral or
multilateral methods. The main methods are:-
1. Clearing Agreements.2. Transfer Moratoria
3. International Liquidity.