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Foreign Exchange Rate: Meaning and Exchange Rate Determination

Factors That Influence Exchange Rates

❶Balance of Payments BOP: The equality between the demand for and supply of foreign exchange signifies also the BOP equilibrium of the home country.

A New Perspective on Money and Inflation

Forex and Commodities

In the context of foreign exchange rate determination, this idea is interesting because it allows us the opportunity to create a valuation model for money, in much the way one might create a valuation model for a stock. Shares represent a proportional claim on the future residual cash flows of the business that issues them.

The monetary base represents a proportional claim on the future output of the society that issues it. Money shares another common feature with traditional equity instruments: Just as the value of a share of common stock depends upon expectations of long-term earnings per share growth, so the value of money depends upon expectations of long-term 20 year plus real output per unit of monetary base growth.

The reasons for the long-duration nature of money are discussed at length in The Velocity Enigma, the final presentation in The Enigma Series. In essence, the principle is the same as building any other valuation model: Nevertheless, there are several complexities involved in doing building a valuation model for money. In our model, the present market value of money, as measured in absolute terms, is equal to the discounted future absolute market value of the goods that unit of money is expected to purchase.

Second, building a valuation model for money requires us to build a probability distribution for when the marginal unit of money demanded may be spent. A share of common stock entitles its holder to a stream of future benefits, but a unt of money only entitles its holder to a slice of future benefits one dollar can only be spent once. In practice, resolving this problem is easier than it sounds because we can leverage the theory of intertemporal equilibrium to create this probability distribution.

A third complexity is that a unit of money can be invested before it is spent: This model provides us with a framework for thinking about what factors drive the value of a fiat currency. If expectations about the long-term prospects of the economy become more pessimistic, i. We can put this in a more familiar context. Finally, we can apply this model to foreign exchange rate determination. As we discussed earlier, a foreign exchange rate is a relative expression of the market value of two currencies.

The Discounted Future Benefits Model, developed in The Velocity Enigma, provides us with a model that determines the market value of an individual currency as measured in absolute terms.

Therefore, all we need to do to convert this into a model for foreign exchange rate determination, a model for the market value of a currency as measured in relative terms , is divide this model for one currency the primary currency by this same model for another currency the measurement currency.

But now, by leveraging the concept that money is the equity of society, we have a model for determining the absolute market value of money that we can use to solve for both Value EUR and Value USD in the price equation above.

In essence, our new model for foreign exchange rate determination states that a foreign exchange rate depends upon long-term 20 year plus expectations of relative future output growth, relative monetary base growth and relative expected investment returns in the two respective countries.

Current levels of the monetary base and real output also matter, but in the end, changes in these current variables tend to be overwhelmed by expectations of the future path of these variables. The key aspect to this model is that it forces us to think about what drives the absolute value of a currency. This is an important idea. Sometimes, a country can opt to have more than one rate at which its currency is exchanged. For further reading, see our Forex Market Tutorial.

How are international exchange rates set? Factors That Influence Exchange Rates Floating rates are determined by the market forces of supply and demand. Forex and Commodities Generally speaking, the more dependent a country is on a primary domestic industry, the stronger the correlation between the national currency and the industry's commodity prices.

Maintaining Rates Some countries may decide to use a pegged exchange rate that is set and maintained artificially by the government. Foreign exchange is the conversion of a country's currency into another. In a free economy, a country's currency is valued Countries attempt to balance interest rates and inflation, but the interrelationship between the two is complex and can influence Aside from interest rates and inflation, the exchange rate is one of the most important determinants of a country's level of economic health.

Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. Read on for what effects these changes can have.

Currency fluctuations often defy logic. Learn the trends and factors that result in these movements. This theory can be applicable to only those countries in case of which the BOP is constituted only by the merchandise trade account. It overlooks completely, the capital transactions and hence is not relevant for those countries in case of which the capital account is of prime significance. In this context, Kindelberger remarked that the PPP theory was designed for trader nations and gives little guidance to a country which is both a trader and a banker.

Given this assumption, the theory proceeds to determine new rate of exchange. Such an assumption may not be true. It may be difficult to locate such a base period because the given country might have been faced with a permanent BOP disequilibrium.

This theory assumes that there are no structural changes in the factors which underlie the equilibrium in the base period. Such factors include changes in tastes or preferences, productive resources, technology etc. The assumption related to constancy of structural factors is clearly unrealistic and the exchange rate is bound to be affected by the changes in these factors. The PPP theory related exchange rate exclusively to the internal price changes in the two countries.

It, thereby, assumed implicitly that there were zero capital movements. Such an assumption is completely invalid. The changes in capital flow have significant bearing upon the exchange rate, through their effects upon the demand for and supply of domestic and foreign currencies. The impact of capital movements upon the rate of exchange had been neglected by this theory.

Another defect in the PPP theory, exposed by Keynes, was its failure to consider the elasticity of reciprocal demand. The rate of exchange between currencies of two countries is determined not only by changes in relative prices but also by elasticities of reciprocal demand. The PPP theory relies upon still another assumption that there is no change in barter terms of trade between two countries.

Even this assumption is not valid as there are frequent changes in the barter terms of trade on account of several factors such as supply of exported goods, demand for foreign goods, external loans etc. The rate of exchange is not influenced only by the relative price changes in two countries.

The demand for and supply of foreign exchange are the fundamental forces to determine the equilibrium rate of exchange. These forces are influenced, apart from transactions of goods, also by such factors as capital flow, cost of transport, insurance, banking etc.

But the PPP theory gives little importance to the forces of demand for and supply of foreign exchange. This theory has been found to be deficient by Ragnar Nurkse on the ground that it considers only the price movement as the determinant of exchange rate. The variations in aggregate income and expenditure that can have effect upon the foreign exchange rate through their effect upon the volume of foreign trade were completely overlooked by this theory. The PPP theory attempts to determine equilibrium rate of exchange under static conditions such as constancy of tastes and preferences, absence of capital movements, absence of transport costs, no changes in tariff, constant technology, absence of speculation etc.

It is highly unrealistic to determine exchange rate with all these over-simplifying assumptions. In the actual dynamic realities, this theory fails altogether. This theory rests on the assumptions of free international trade and laissez faire.

It means the government does not resort to tariff or non-tariff restrictions upon trade. Even these assumptions do not hold valid in actual reality. There is frequent use of tariffs, quotas and other controls by the governments in both advanced and poor countries.

The restrictions on trade do have a definite impact upon the rate of exchange. It signifies that the PPP theory is completely incapable of determining the rate of exchange in actual life. Vanek held the belief that the PPP theory at best could serve as a crude approximation of the equilibrium rate of exchange.

With its over-simplifying assumptions, it can neither exactly measure the rate of exchange nor can make a precise forecast of it over future period.

This theory fails to take cognizance of change in international economic relations. If originally trade was taking place between two countries, the appearance of a third country either as a purchaser or as a buyer of a particular commodity can have a significant effect on the volume and direction of trade as well as on demand and supply conditions pertaining to the foreign exchange.

Therefore, this theory is not capable of providing a proper measure of rate of exchange in the more realistic conditions of multi-country trade. The PPP theory can be considered relevant only in the long period when the disturbances are of purely monetary character.

No doubt, there are serious theoretical and practical deficiencies in the PPP theory, yet it is indisputably a highly sensible explanation of rate of exchange in such countries where the price movements have a major impact on the exchange rate.

This theory can explain the determination of rate of exchange not only under inconvertible paper standard but under every possible monetary system. The long term tendency of exchange rate can be stated more appropriately through relative price movements and that underlines the practical importance of this theory.

Despite weaknesses of both the absolute and relative versions of the PPP theory, the assumptions of this theory are central to many a model. The empirical studies have been made to assess the validity of the PPP hypothesis. These studies have attempted to deal with three issues. First, whether the Law of One Price holds and whether it is possible to construct price indices that would follow that law. The studies made in this regard attempted by Isard and Kravis and Lipsey have given the conclusion that the Law of One Price does not hold true.

They also indicate that changes in exchange rate result in variations in relative prices that make it apparently impossible to construct price indices for which the Law of One Price will hold. Second, the empirical studies attempt to estimate the generalised form of equation and test whether the parameters differ significantly or not from those predicted by PPP. In this connection, the regression-based studies tend to suggest that the PPP hypothesis is not acceptable in the short term.

It may, however, do better in the long run. Third, the issue is whether or not PPP provides efficient forecasts of exchange rate movements over time. In this regard, the time series are based on more sophisticated models involving interest rates, rational expectations and price levels. They proceed to examine the markets.

The evidence, in this context, is conflicting. While Mac Donald concluded that the market was efficient, Frankel and Froot arrived at the opposite conclusion. The evidence on balance is against this theory except in the long run. The balance of payments theory of exchange rate maintains that rate of exchange of the currency of one country with the other is determined by the factors which are autonomous of internal price level and money supply.

It emphasises that the rate of exchange is influenced, in a significant way, by the balance of payments position of a country. A deficit in the balance of payments of a country signifies a situation in which the demand for foreign exchange currency exceeds the supply of it at a given rate of exchange. The demand for foreign exchange arises from the demand for foreign goods and services.

The supply of foreign exchange, on the contrary, arises from the supply of goods and services by the home country to the foreign country. In other words, the excess of demand for foreign exchange over the supply of foreign exchange is coincidental to the BOP deficit. The demand pressure results in an appreciation in the exchange value of foreign currency. As a consequence, the exchange rate of home currency to the foreign currency undergoes depreciation.

A balance of payments surplus signifies an excess of the supply of foreign currency over the demand for it. In such a situation, there is a depreciation of foreign currency but an appreciation of the currency of the home country. The equilibrium rate of exchange is determined, when there is neither a BOP deficit nor a surplus.

In other words, the equilibrium rate of exchange corresponds with the BOP equilibrium of a country. The determination of equilibrium rate of exchange can be shown through Fig.

D is the negatively sloping demand function of foreign currency. S is the positively sloping supply function of foreign currency. The equality between the demand for and supply of foreign exchange signifies also the BOP equilibrium of the home country. If the rate of exchange is OR 1 which is higher than the equilibrium rate of exchange OR 0 , the demand for foreign currency D 1 R 1 falls short of the supply of foreign currency S 1 R 1.

In this situation, the home country has a BOP surplus. The excess supply of foreign exchange lowers the exchange value of foreign currency relative to home currency. The appreciation in the exchange rate of home currency reduces exports and raises imports.

In this way, the BOP surplus gets reduced and the system tends towards the BOP equilibrium and also the equilibrium rate of exchange. If the rate of exchange is OR 2 which is lower than the equilibrium rate of exchange OR 0 , the demand for foreign currency D 2 R 2 exceeds the supply of foreign currency S 2 R 2.

As a result of the excess demand for foreign currency, the exchange value of foreign currency appreciates while the home currency depreciates. The depreciation of the exchange value of home currency leads to a rise in exports and a decline in imports.

Thus the BOP deficit gets reduced and the exchange rate appreciates to approach finally the equilibrium rate of exchange OR 0 where the BOP is also in a state of equilibrium. If there are changes in demand or supply or both, the rate of exchange will be accordingly influenced. Apart from the changes in demand and supply, the rate of exchange is affected by the foreign elasticity of demand for exports, the domestic elasticity of demand for imports, the domestic elasticity of supply of exports and the foreign elasticity of supply of imports.

The stability of the equilibrium rate of exchange requires that the demand elasticities should be high whereas the supply elasticities should be low. The balance of payments theory of rate of exchange has certain significant merits. Firstly, this theory attempts to determine the rate of exchange through the forces of demand and supply and thus brings exchange rate determination in purview of the general theory of value. Secondly, this theory relates the rate of exchange to the BOP situation.

It means this theory, unlike PPP theory, does not restrict the determination of rate of exchange only to merchandise trade. It involves all the forces which can have some effect on the demand for and supply of foreign currency or the BOP position.

Thirdly, this theory is superior to both the PPP theory and mint parity theory from the policy point of view. It suggests that the disequilibrium in the BOP can be adjusted through marginal variations in the exchange rate, viz.

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The equilibrium exchange rate is determined at that point where demand for foreign exchange equals supply of foreign ex­change. In Fig. , DD 1 and SS 1 curves inter­sect at point E. The foreign exchange rate thus determined is OP. At this rate, quantities of foreign exchange demanded (OM) equals quantity supplied (OM).

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FOREIGN EXCHANGE RATE• It is the rate at which one currency will be exchanged for another in foreign exchange.• It is also regarded as the value of one country’s currency in terms of another currency.

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Exchange Rate Determination. Foreign exchange markets are amoung the largest markets in the world with an annual trading volume in excess of $ trillion. It is an over-the-counter market, with no central trading location and no set hours of trading. Prices and other terms of trade are determined by computerized negotiation. 17 The Theory of Exchange Rate Determination money supplies also experience rapid depreciation of the foreign exchange value of their money, relative to the monies of countries with much less.

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ADVERTISEMENTS: This article throws light upon the three theories of determination of foreign exchange rates. The theories are: 1. Purchasing Power Parity Theory 2. Interest Rate Theories 3. Other Determinants of Exchange Rates. Determination of Exchange Rates: Theory # 1. Purchasing Power Parity Theory: Assuming non-existence of tariffs . In our case of the determination of exchange rate between US dollar and Indian rupee, the Indians sell rupees to buy US dollars (which is a foreign currency) and the Americans or others holding US dollars will sell dollars in exchange for rupees.