Exchange Rate Determination

Introduction

An Exchange rate is the price of one nations currency in terms of another currency, often termed as the reference currency.

E.g. the rupee/dollar exchange rate is just the number of Rupees that one dollar will buy if a dollar will buy 46 Rupees then the exchange rate could be expressed as Rs.46/$ and Rupees will be the reference currency.. Similarly, the dollar/Rupees exchange rate is the number of dollars one Rupees will buy following the same example the exchange rate would be $0.21/Rs.

International transactions require the exchange of one countrys currency for another. To buy or sell goods and services

When a currency becomes more valuable relative to another currency it is said to be appreciated. The price of the foreign exchange has fallen (e.g. 1 USD buys Rs. 45 instead of Rs. 39 earlier). When a currency becomes less valuable relative to another currency, it is said to be depreciated. The price of the foreign exchange has risen (e.g. 1 USD buys Rs. 39 instead of Rs. 45)

Exchange Rate Determination

Supply and Demand

The more people want a certain currency the higher the foreign exchange rate will be of such currency

Differentials in Inflation
Inflation Rate

Inflation Rate

Purchasing power Depreciation of currency

Purchasing power Appreciation of currency

U.S. inflation
demand for Indian goods i.e. 1 USD Rs.48 to Rs 46(depreciate)
U.S. Indian

desire for U.S. goods

Differentials in Interest Rates

Interest Rates Will attract capital from abroad So demand for the currency increase Therefore the currency will appreciate

Current-Account Deficits

Current account includes details of trade transactions with other nations and reflects payments made and received Deficit balance in the account indicates that the country spends more than it earns Increase foreign debt to meet the difference

Terms of Trade

Exports, imports and the trade balance can influence the demand of currency If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved In turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value)

e.g. if the United States is running a trade surplus, there will be demand from overseas for the USD to pay for these goods so that there is a pressure for appreciation

Political Stability and Economic Performance

Foreign investors seek out stable countries with strong economic performance in which to invest their capital Exchange rates can also fluctuate if there is a change in government Downgrading of US credit rating

Structural Changes
1)An increase in investment spending 2) Fiscal stimulus 3) A decline in private savings

Investment spending domestic investment in a country will help to strengthen a countrys

currency. For example, the United States experienced an investment boom in the 1990s.

Fiscal stimulus government investment in a

country can also help strengthen a countrys currency. For example, Turkey has enjoyed fiscal stimulus and government spending in recent years.

Private savings the citizens of a countrys

tendency to save will help strengthen a countrys currency. For example, Japan has had a large and persistent current-account surplus that has led to a stronger currency.

Purchasing Power Parity

"one price law" according to which any freely good or service has the same price worldwide For e.g. if a hamburger costs 3 US dollars in the United States and 100 yen in Japan, then the exchange rate must be 100 yen per dollar