FOREIGN EXCHANGE

M.Bashyakar
 Rate of Exchange
• The rate at which one unit of a country’s
currency is exchanged for a number of units of
the currency of another is the "exchange rate"
between them. Presently one pound sterling
exchanges for Rs. 78 and U.S. dollar for Rs.
48.50 This is our rate of exchange with the
U.K. and the U.S.A respectively.
• Every country has a currency different from
others. There is no common medium of
exchange. It is this feature that, among others,
distinguishes international from domestic
trade.

02/08/10 M.Bashyakar 2
 Rate of Exchange ( cont)
When the imports and exports of a country are
equal, the demand for foreign currency and
its supply, or, conversely, the supply of home
currency and the demand for it will be equal.
The exchange rate will be at par.
If the supply of foreign currency is greater than
the demand, it falls below par and the home
currency will appreciate.
If on the other hand, the home currency is in
greater supply, there will be higher demand
for the foreign currency.

02/08/10 M.Bashyakar 3
 Under the Gold Standard
If two currencies are on the gold standard and
their currencies are expressed in terms of a
weight of gold, the rate of exchange is
determined simply by reference to the gold
content of the two currencies. Suppose India
and the United States are on the gold
standard, the rupee being equal to 1 grain of
gold and the dollar 50 grains of gold, the rate
of exchange between these two countries will
be:
1 Rupee = 1/50 = 1/50 dollar or
∴ One Dollar = Rs. 50/-

02/08/10 M.Bashyakar 4
Thus, the rate of exchange is determined in a direct
manner by equating the gold content of the two
currencies. This rate of exchange is known as the Mint
Par of Exchange; So at the Indian mint, one rupee will
be equal to one grain of gold.
The actual rate in the foreign exchange market will be
slightly different from the Mint Par of Exchange to
allow for certain expenses, such as bank commission,
shipping and insurance charges of sending gold from
one country to the other. However, the actual rate of
exchange between currencies will not depart much
from the mint par and will move between the two
points of export and import of gold.

02/08/10 M.Bashyakar 5
 These points are also called "Specie Points" or "Gold
Points". These points are worked out by adding or
subtracting the various charges, viz., bank
commission, shipping and insurance charges of
sending gold from one country to the other. Thus,
under gold standard, the rate of exchange is fixed
by gold content. Rate may deviate slightly from the
ratio of gold contents by the amount of bank
commission and the transportation charges, etc.

02/08/10 M.Bashyakar 6
 Gold Exchange
Standard
Take two countries, one having gold standard,
say Britain, and the other silver standard, say
India. How will the rate of exchange between the
British pound and Indian rupee be determined? In
order to clear their dues, the Indian importers
wish to buy the British currency, which is gold
with the Indian rupees, which is silver. Hence, the
rate in Bombay will depend on the price of gold in
terms of silver. In the same manner, in London
the rate of exchange will depend on the price of
silver in terms of gold.

02/08/10 M.Bashyakar 7
 Paper Currency Standards:
Purchasing Power Parity
Theory
No country today is rich enough to have pure
gold standard - not even the (U.S.A). All
countries are on paper currencies. The
exchange situation is difficult in such cases. It
becomes complex when both the countries
have inconvertible paper currencies or one is on
a gold standard and the other on an
inconvertible paper standard. In such
circumstances, the ratio of exchange between
the two currencies is determined by their
respective purchasing powers.

02/08/10 M.Bashyakar 8
 PURCHASING POWER
PARITY THEORY
The Purchasing Power Parity Theory was
propounded by Professor Gustav Cassel of
Sweden. According to this theory, the rate of
exchange between two countries depends upon
the relative purchasing powers of their
respective currencies. Such will be the rate,
which equates the two purchasing powers. For
example, if a certain assortment of goods can be
had for £1 in Britain and a similar assortment
with Rs.82 in India, then it is clear that the
purchasing power of £1 is equal to the
purchasing power of Rs.82.
02/08/10 M.Bashyakar 9
Thus, the rate of exchange, according to
purchasing power parity theory, will be £1
= Rs.82.At a particular time, the rate of
exchange between the two countries may
not reflect the relative purchasing power of
the two currencies; yet we might say that
such forces will be set into motion that the
parity between the purchasing powers of
the two currencies will be restored. Thus,
between countries on inconvertible paper,
the place of the mint par is taken by the
purchasing power parity.
02/08/10 M.Bashyakar 10
 The difference is that the former is a fixed par
while the latter moves with movement of the
price levels in the two countries concerned.
Day-to-day fluctuations around this par will
take place as before due to changes in the
supply of and demand for the currency in
question. The limits of these fluctuations will
be set by the cost of transporting goods from
one country to another. Hence, these limits will
not be definite as were the specie points.

02/08/10 M.Bashyakar 11
 Criticism
The purchasing power parity theory has been
subjected to the following criticism.

1.The actual rates of exchange between the two

countries seldom reflect the relative purchasing
powers of the two currencies. This may be due to
the fact that governments have either controlled
prices or controlled exchanges or imposed
restrictions on import and export of goods.

2. The theory is true if we consider the

purchasing power of the respective currencies in
terms of goods, which enter into international
trade, and not the purchasing power of goods in
general. But we know that all articles produced in
a country do not figure in international trade.
02/08/10 M.Bashyakar 12
3.It is very difficult to measure purchasing power of
the currency. It is usually done with the help of
Index Numbers. But we know that the Index
Numbers are not infallible. Among the difficulties
connected with Index Numbers are the following
important ones; (i) Different types of goods enter
into the calculation of Index Numbers; (ii) Many
goods which may enter into domestic trade may
not figure in international trade; (iii)
Internationally traded goods also may not have
the same prices in all the markets because of
differences in transport costs.

02/08/10 M.Bashyakar 13
4.The theory of purchasing power applies to a
stationary world. Actually the world is not static but
dynamic. Conditions relating to money and prices,
tariffs, etc., constantly go on changing and prevent
us from arriving at any stable conclusion about the
rates of exchange. The internal prices and the cost
of production are constantly changing. Therefore, a
new equilibrium between the two currencies is
almost daily called for. As Cassel observes,
"Differences in two countries' economic situation,
particularly in regard to transport and customs, may
cause the normal exchange rate to deviate to a
certain extent from the quotient of the currencies'
intrinsic purchasing powers. If a country puts up
tariffs, the exchange value of its currency will rise
but its price-level will remain the same.

02/08/10 M.Bashyakar 14
5.Besides, many items of balance of payments
like insurance and banking transactions and
capital movements are very little affected by
changes In general price-levels. But these
items do influence exchange rates by acting
upon the supply of, and the demand for,
foreign currencies. The Purchasing Power Parity
Theory ignores these influences altogether.

6.The theory, as propounded by Cassel, says that

changes in price level bring about changes in
exchange rates but changes in exchange rates
do not cause any change in prices. This latter
part is not true, for exchange movements do
exercise some influence on internal prices.

02/08/10 M.Bashyakar 15
7. Purchasing power parity theory assumes that
there is a direct link between the purchasing
power of currencies and the rate of exchange.
But in fact there is no direct relationship
between the two. Exchange rate can be
influenced by many other factors, such as
tariffs, speculation and capital movements.
8. Purchasing power parity theory compares the
general price levels in two countries without
making any provision for distinction being
drawn between the price level of domestic
goods and that of the internationally traded
goods. The prices of internationally traded
goods will tend to be the same in all countries
(transport costs are, of course, omitted).
Domestic prices, on the other hand, will be
different in the two countries, even between
two areas of the same country.

02/08/10 M.Bashyakar 16
 BALANCE OF PAYMENTS
THEORY
The most satisfactory explanation of the
determination of the rate of exchange is that a
free exchange rate tends to be such as to
equate the demand and supply of foreign
exchange. For example, the external value of
the rupee in Chennai depends on the demand
for and supply of rupees on the foreign
exchange market in Chennai. The demand for
rupees comes from those who offer foreign
exchange in order to obtain rupees, while the
supply of rupees comes from those people who
are offering rupees to obtain foreign exchange.

02/08/10 M.Bashyakar 17
The Indian exports to the U.K. constitute the
demand for rupees, for they have a claim on pound
sterling which they want to convert into rupees; and
the Indian importers who have to make payments to
the U.K. offer rupees in order to get pound sterling.
The intersection of the sterling supply curve and the
sterling demand curve gives the equilibrium price of
sterling that equates the amount of pound sterling
offered and the amount of pound sterling demanded.
That is why the modern theory is also called the
Balance of Payments Theory of Foreign Exchange.
The demand for foreign exchange arises from the
debit items in the balance of payments, whereas the
supply of foreign exchange arises from credit items.

02/08/10 M.Bashyakar 18
As an illustration, if India has a net debit, its demand
for foreign exchange, say pound sterling, must exceed
its supply of pound sterling with the result that the
rupee price of pound sterling will go up or, what comes
to the same thing, the external value of the rupees
must go down relative to pound sterling. The rupee
becomes cheaper in terms of £. Conversely, a net
credit in India’s balance of payments will lead to a fall
in the rupee price of £, which means a higher value of
the rupee or expensive rupee relative to the £.
When the balance of payments is unfavorable, the
country will have a weak exchange rate position.

02/08/10 M.Bashyakar 19
 If a country has a surplus on current
account, it is said to have a favorable
balance of payments. There are more
people abroad who have to make
payments to this country. The demand
for this country’s currency will increase
abroad. The result will be that the
external value of the domestic currency
will appreciate. This is how the balance of
payments affects demand for and supply
of foreign exchange that determines the
rate or exchange.

02/08/10 M.Bashyakar 20
 Merits of the Theory
The main merit of the theory is that it brings the determination of
exchange rate problem within the purview of the general
equilibrium analysis.
Secondly, the theory stresses the fact that there are many other
forces besides merchandise items (exports and imports of goods)
included in the balance of payments which influence the supply of
and demand for foreign exchange, which in turn determine the rate
of exchange. Thus, the theory is more realistic in that the domestic
price of foreign money is seen as a function of many significant
variables, not just purchasing power expressing general price levels.

02/08/10 M.Bashyakar 21
 Furthermore, the greatest significance of the
theory is that it shows that disequilibrium in
the balance of payments position can be
corrected by marginal adjustments in the
exchange rate by devaluation or revaluation
rather than through internal price inflation or
deflation as implied by the mint parity theory.

02/08/10 M.Bashyakar 22
Criticisms

1.The fundamental defect of the theory is that it

assumes perfect competition, including no
interference with the movement of money from
one country to another. This is very unrealistic.

2. According to the theory, there is no causal

connection between the rate of exchange and
the internal price level. But, In fact, there should
be some such connection, as the balance of
payments position may be influenced by the
price-cost structure of the country.

02/08/10 M.Bashyakar 23
3. The theory advocates that the rate of exchange is
the function of the balance of payments. But, in
practice it has also been found that the balance of
payments position of a country is very much
affected by the changes in the rate of exchange.
Thus, it is equally true that the balance of
payments is the function of the rate of exchange.
In this sense, the theory is indeterminate as it
confuses as to what determines what
4. According to the theory, the optimum value of a
currency is the gold content embodied in it. This is
not true for a flat paper standard. Thus, the
demand-supply theory fails to explain the basic
value incorporated in currencies.

02/08/10 M.Bashyakar 24
5. In fact, the balance of payments theory of
exchange rate is merely a truism–a self-evident fact
without any casual explanatory significance. Critics
argue that if payments must necessary balance,
there can be no meaning to a decline in the
exchange rate during an unfavorable trade balance,
an uncovered balance simply does not exist.

02/08/10 M.Bashyakar 25
 CAUSES OF FLUCTUATIONS IN
EXCHANGE RATE
The various theories of exchange rate determination
seek to explain only the equilibrium or normal long
period exchange rates. Market rates (or day-to-day
rates) of exchange are however subject to fluctuations
in response to the supply of and demand for
international money transfers. In fact, there are various
factors which affect or influence the demand for and
supply of foreign currency (or mutual demand for each
other’s currencies) which are ultimately responsible for
the short-term fluctuations in the exchange rate.
Important among these are:

02/08/10 M.Bashyakar 26
 1. Trade Movement
Any change in imports or exports will
certainly cause a change in the rate of
exchange. If imports exceed exports, the
demand for foreign currency rises; hence
the rate of exchange moves against the
country. Conversely, if exports exceed
imports, the demand for domestic
currency rises and the rate of exchange
moves in favour of the country.

02/08/10 M.Bashyakar 27
 2. Capital Movements
International capital movements from one country to
another may either be for short periods to avail of the
high rate of interest prevailing abroad or for long
periods for the purpose of making long-term
investment abroad. Any export or import of capital
from one country to another will bring about a change
in the rate of exchange. If a large amount of capital is
shifted from England to India the demand for Indian
rupees (or the supply of British pounds) in the
exchange market increases so that the exchange value
of the rupee in terms of pound increases. That is to say
rupee will appreciate in value in terms of pounds. The
reverse will happen when there is a flight of Indian
capital to England.

02/08/10 M.Bashyakar 28
 3. Stock Exchange
Operations
These include granting of loans, payment of interest on
foreign loans, repatriation of foreign capital, purchase
and sale of foreign securities etc. which influence
demand for foreign funds and through it, the exchange
rates. For instance, when a loan is given by the home
country to a foreign nation the demand for foreign
money increases and the rate of exchange tends to
move unfavourably for the home country. But, when
foreigners repay their loan, the demand for home
currency exceeds its supply and the rate of exchange
becomes favourable.

02/08/10 M.Bashyakar 29
 4. Speculative
Transactions
These include transactions ranging from
anticipation of seasonal movements in
exchange rates for the extreme one viz.,
flight of capital. In periods of political
uncertainty there is heavy speculation in
foreign money. There is a scramble for
purchasing certain currencies and some
currencies are unloaded. These
speculative activities bring about wide
fluctuations in exchange rates.
02/08/10 M.Bashyakar 30
 5. Banking Operations
Banks are the major dealers in foreign exchange.
They sell drafts, transfer funds, issue letters of
credit, accept foreign bills of exchange, take up
arbitrage operations etc. These operations
influence the demand for and supply of foreign
exchange and hence the exchange rates. Bank rate
also exerts a significant influence on the rate of
exchange. A rise in bank rate attracts foreign funds
hence the demand for home currency rises and the
rate of exchange moves up. The opposite happens
when the bank rate is lowered.

02/08/10 M.Bashyakar 31
 6. Monetary Policy
An expansionist monetary policy has generally an
inflationary impact, while a contractionist policy
tends to have a deflationary influence. Inflation and
deflation bring about a change in the internal value
of money. This reflects itself a similar change in the
external value of money. Inflation means a rise in
the domestic price level, fall in the internal
purchasing power of money, and hence a fall in the
exchange rate. On the other hand, a deflationary
policy leads to a fall in the domestic prices and rise
in the exchange rate.

02/08/10 M.Bashyakar 32
 7. Political Conditions
Political stability of a country can help very much to
maintain a high exchange rate for its currency, for
it attracts foreign capital which causes the foreign
exchange rate to move in is favour. Political
instability on the other hand causes a panic flight
of capital from the country; hence the home
currency depreciates in the eyes of foreigners and
consequently its exchange value falls. In fact,
political conditions in a country are a potent factor
both in exchange speculation and in the
international movement of capital.

02/08/10 M.Bashyakar 33
 However, fluctuations in the rate of exchange
in the short period are confined within certain
limits. Under the gold standard system,
these limits were set by gold or specie points
as determined by the mint par. Under
inconvertible paper standard, however, the
purchasing power parities of the two
countries set such limits. The purchasing
power par, however, unlike the mint par, is
not fixed.

02/08/10 M.Bashyakar 34
 FIXED AND FLEXIBLE
EXCHANGE RATES
Under inconvertible paper currency standard,
there can be two types of exchange rates - fixed
and flexible. Under the present monetary system
of the International Monetary Fund (IMF), fixed or
stable exchange rates are known as pegged
exchange rates or par values.

Under the system of fixed pars, as adopted by the

IMF member nations, the exchange rate is
determined by the government and enforced
either by pegging operations, or by resorting to
some form of exchange control and sometimes by
a healthy combination of both these methods.
02/08/10 M.Bashyakar 35
 FIXED AND FLEXIBLE
EXCHANGE RATES (cont)
Under the pegging operation, the government fixes an
official par of exchange and tries to enforce it through
central bank or a kind of exchange stabilization fund
which enter the foreign exchange market and purchase
its currency when the market rate falls below the
specified level and sell it when the rate rises above a
particular mark. This system of pegged rates of
exchange is government propped up. There is,
however, one major defect in this system is that if the
market rate of exchange has a consistent tendency to
decline, pegging operations would be very expensive,
as it would lead to a heavy reduction in the exchange
reserves of the country concerned.

02/08/10 M.Bashyakar 36
 CASE FOR FIXED EXCHANGE
RATES
The following advantages are claimed for the
system of stable or fixed exchange rates as
against the flexible exchange rates:
▪ Stable exchange rates ensure certainty and
confidence and thereby promote international
trade. Foreigners can easily know how much
they will have to pay and how much they will
receive in terms of the home currency. Instability
in exchange rates constitutes an additional risk
in international trade, which hampers its growth.

02/08/10 M.Bashyakar 37
• A system of stable exchange rates
will facilitate long-term international
investments. With an unstable
exchange rate, lenders and investors
will not be prepared to lend for long-
term investments. Thus, a system of
stable exchange rates is essential for
the orderly growth of international
investment markets.

02/08/10 M.Bashyakar 38
• A fixed rate of exchange is more suited to a world of
currency areas, such as the sterling area.

• Fixed exchange rates will remove the dangerous possibilities

of speculation. In a system of stable exchange rate, there will
be no panic flight of capital from one country to another.

• A stable exchange rate will also assist in international

economic stabilization. On the other hand, freely fluctuating
exchange rates encourage abnormally high liquidty
preference, which leads to hoarding, to higher rates of
interest, to shrinking of investment and to unemployment

02/08/10 M.Bashyakar 39
• For small countries like Singapore, Hong
Kong, Denmark and Great Britain in whose
economy foreign trade plays a crucial
role, stabilization of the exchange rate is
the only right policy. For if the country
does not stabilize her exchange rate
fluctuations in the rate of exchange, it will
disturb her foreign trade and with it the
prosperity and growth of the country.

02/08/10 M.Bashyakar 40
 Advantages of Flexible Rates

(i) The system of flexible exchange rates is a simple

one. The exchange rate moves in a free
market to equate supply and demand, so that the
market is cleared off and the problem of scarcity or
surplus of any one currency is automatically
solved. Hence, under the flexible exchange rate
system, the countries do not have to make extra
efforts in inducing changes in prices and incomes
in order to maintain or re-establish equlibrium in
the balance of payments.

02/08/10 M.Bashyakar 41
(II) Being very sensitive, the system of flexible
rates facilitates continuous adjustments, so that
the adverse effect of prolonged periods of
disequilibrium is avoided (which is commonly
found in the present fixed rate system.)

(III) It is the only system, which permits the

continued existence of free trade and
convertible currencies. This system does not
require the use of exchange controls, which is
generally associated with the system of pegged
rates.

02/08/10 M.Bashyakar 42
(iv) The flexible exchange rates system also confers
more Independence on the countries in their
domestic policies.

(v) Sohmen argues that flexible rates system tends to

reinforce the effectiveness of monetary policy. For
example, when a country seeks to expand output,
it may lower interest rates. But the lowering of
interest rate, under the flexible exchange rates
systems, will cause an outflow of capital, a rise in
the spot rate, and a rise in exports relative to
imports. The trade balance, as such will move
favourable which will reinforce the expansionary effect
of lower interest rate on domestic spending, thus
making the monetary policy more effective.

02/08/10 M.Bashyakar 43
(vi) The system of flexible exchange rates eliminates
the need for official foreign exchange reserves, if
individual governments do not employ stabilisation
funds to influence the rate. It thus solves the problem
of international liquidty automatically.

Prof. Nurkse remarks: "Fluctuating exchange rates

cause constant shifts of domestic factors of production
between export and home-market industries, shifts
which may be disturbing and wasteful“.

02/08/10 M.Bashyakar 44
 EXCHANGE CONTROL

Objective of Exchange Control

The chief objective of exchange control by

a country is to restore equilibrium in its
payments. If a country finds that its
balance of trade has been persistently
unfavourable, then it must do something
to set it right. The balance of payments
must ultimately be made to balance.

02/08/10 M.Bashyakar 45
 Methods of Exchange
Control
There are as many as 41 different methods of
exchange control. Broadly speaking, these
methods may be classified into two types:
direct and indirect methods. Direct methods
consist mainly of intervention, restriction and
exchange clearing agreements. Indirect
methods of exchange control consist of
quantitative restrictions on international
trade and interest rate changes to influence
the rate of exchange.

02/08/10 M.Bashyakar 46
 Direct Methods
(a) Intervention: For an effective control of foreign
exchange rates and foreign exchange market, the
government should have a central authority - the
central bank - which should have complete power
to control and regulate foreign exchange market.
Anyone wanting foreign exchange should purchase
it only from the central authority and from no other
source. Likewise, anyone wanting to sell foreign
exchange should sell it only to the central
authority. The buying and selling of foreign
exchange by a single authority shall enable the
latter to adjust demand and supply of foreign
exchange according to the needs of the country.

02/08/10 M.Bashyakar 47
 Government Intervention: In the foreign exchange
market, it takes the form of "pegging-up" or "pegging
down" the currency of the country to a chosen rate of
exchange. The pegging operations take the shape of
buying and selling of the home currency either by the
Government or by the central bank of the country
exchange for the foreign currency In the foreign
exchange market Intervention of the Government In the
foreign exchange market has the effect of influencing
the forces of demand and supply of foreign exchange.
Besides in order to carry on intervention, the
authorities must have reserves of both local and foreign
currencies. If that is not possible, the Government will
either have to resort to the alternative method of direct
exchange control, via" restriction, or the Government
will fail in their purpose of controlling the rate of
exchange.

02/08/10 M.Bashyakar 48
(b) Restriction: A more powerful weapon of
exchange control has been devised in
exchange restriction. Exchange restriction
refers to the policy by which the Government
restricts the supply of its currency coming
into the exchange market.
Exchange restriction was first adopted by
Germany in 1931, where non-compliance of
currency regulation was punishable with
death. During the Second World War, many
other countries followed the German
example.

02/08/10 M.Bashyakar 49
(c) Exchange Clearing Agreements.
Exchange clearing is a method of exchange
control, which was practiced during the
Depression of 1930's. Under it, two
countries engaged in trade pay to their
respective central banks the amounts
payable to their respective foreign
creditors.
However. the exchange clearing
agreements suffer from an important
defect, that there is a possibility of
economic exploitation of a weaker
country by a powerful country.

02/08/10 M.Bashyakar 50
 Indirect Method of
Exchange Control
Restriction of Imports by the use of tariffs leads to
the decline of the demand for foreign currency
and exports are increased, the rate of exchange
will go up in favor of the country imposing import
restrictions. In this sense, import duties and other
quantitative restrictions may have an effect on
the rate of exchange but an import duty, imposed
specifically to protect local industries against
foreign competition cannot be properly called a
method of exchange control since the main
objective is to restrict imports.

02/08/10 M.Bashyakar 51
 Exchange Rate in India
• As part of economic reforms, partial convertibility
of the rupee on current account was introduced in
March 1992. under this Liberalised Exchange Rate
Management System (LERMS), 60% of all receipts
under current transactions (merchandise exports
and invisible receipts) could be converted at the
free market exchange rate quoted by authorised
dealers. For he remaining 40% the rate is the
official rate fixed by the RBI. Full convertibility of
the Rupee on trade account was introduced by
the 1993 -94 budget.

02/08/10 M.Bashyakar 52
• With regard to Capital Account convertibility
(CAC), the Tara pore Committee which submitted
its report on 30 May 1997 laid down a 3- year
roadmap (1999 – 2000). However the move
towards CAC has been tardy. Further, the South –
East Asian economic crisis has created a great
deal of scepticism about CAC

• Since the 1980’s the RBI has been experimenting

with a managed float, pegging the rupee to dollar
and pound sterling alternatively depending on
which was going down, to guard against the
appreciation of the rupee that would adversely
affect the country’s exports.

02/08/10 M.Bashyakar 53
 Foreign Exchange and
Management Act (FEMA)
• Effective from Jan. 1, 2000, enacted to facilitate external
trade and payments and to promote orderly development
and maintenance of Forex market. It empowers the
government to impose restrictions on dealings in foreign
exchange and foreign security, payments to and receipts
from any person outside India. It also imposes restrictions
on persons residents in India on acquiring, holding or
owning foreign exchange security and immovable
property abroad and on transfer of foreign exchange or
security abroad. RBI plays a decisive role in the
administration of FEMA.

02/08/10 M.Bashyakar 54