MEANING AND CALCULATION OF FOREIGN EXCHANGE

SANYA JUNEJA PGDIM 11-12 Roll no. 38

 The fact that all open economies are economically

interlinked and independent to some extent gives rise to the concept of foreign exchange.
It is the rate at which currency of a country can be

bought and sold against the currency of another country in the foreign exchange market
Example: US $= Rs 44.60 ( 1 US $ can be

purchased for 44.60 INR)

DETERMINATION OF FOREIGN EXCHANGE RATE IN A FREE MARKET

 Applies to free market conditions

No government intervention No restriction on holding and transacting foreign currency

The demand for foreign exchange is derived from demand for foreign goods, services and securities. The supply curve is derived from a composite supply of foreign exchange by:
* speculators, * foreign exchange dealers and * monetary authorities trying to get rid of excess foreign currency

 DD1 shows Inverse relation between demand

for foreign exchange and exchange rate.

Equilibrium Exchange rate : $1= Rs.50, the intersection of DD1 and SS at point P.

 In case, $ increases for some reason, say,

increase in demand for the US goods, DD1 shifts out to DD2

New Equilibrium Exchange rate : $1= Rs.60, the

intersection of DD2 and SS at point P.

Thus market will be cleared at $12.5 million.

PURCHASING

POWER PARITY THEORY

This asserts that relative value of different

currencies correspond to the relation between the real purchasing power of each currency in its own country.
Eg; suppose a basket of goods and services can

be bought in India for Rs.100 and in US for $2, then absolute exchange rate will be: $2 = Rs 100 or $1 = Rs 50

 Absolute exchange rate is unrealistic as it

assumes: * no cost of transportation * no tariffs and no subsidies thus, relative exchange rate emerged.
Relative purchasing power parity determines the

exchange rate between any two currencies with changing prices. Because it takes into account the inflation rates and other factors causing a change in price levels.

 P0A and P0B : price levels in countries A and B in

year 0. P1A and P1B : price levels in countries A and B in year 1. R0 : exchange rate between the two currencies in year 0.
then the exchange rate R1 in year 1 is

R1 = R0 P1A/P0A P1B/P0B

 PPP theory can be used as the first

approximation of an equilibrium rate of exchange for periods of serious and frequent price changes.
However, for a more accurate measure of the

exchange rate , other factors like

Capital transfers Changes in production techniques Changes in real incomes , needs to be accounted for .