15. Foreign exchange rate
-The price of a currency
An exchange rate is the rate at which one currency can be exchanged for another.
In other words, it is the value of another country's currency compared to that of your own.
Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other
TYPES OF CURRENCY
Hard currency:-It is usually fully convertible and strong or relatively stable in value in comparison with other currencies.
Exotic currency:-It is currency of a developing country and is often unstable, weak and unpredictable.
There are five main players in this global arena...
The United States (USD) , The European Union (EURO) , Great Britain (GBP) , Japan (JPY) , Switzerland (CHF)
16. Arbitrage
Arbitrage is the practice of taking advantage of a state of imbalance between two or more markets. A person who engages in arbitrage is called an arbitrageur. The arbitrageur exploits the imbalance that is present in the market by making a couple of matching deals in different markets, with the profit being the difference between the market prices.
17. Nominal exchange Rate
THE nominal exchange rate is simply the price of one currency in terms of the number of units of some other currency. This is determined by fiat in a fixed rate regime and by demand and supply for the two currencies in the foreign exchange rate market in a floating rate regime.
It is 'nominal' because it measures only the numerical exchange value, and does not say anything about other aspects such as the purchasing power of that currency. In a floating rate regime, an increase in the value of the domestic currency against other currencies is called an appreciation, while a decrease in value is called depreciation.
In contrast, an increase in the exchange rate in a fixed rate regime is called a revaluation (for an increase) and a decrease in the exchange value of the domestic currency is referred to as a devaluation.
When we say that $1=Rs. 40 we are talking about nominal exchange rate. This is the rate at which you can purchase dollars.
Now that we understand what is “Nominal” exchange rate, let’s understand what “Real” exchange rate is all about…
To understand this let’s consider an analogy:-
Let’s say the nominal exchange rates between the currencies of US & India are in the ratio of 1:40.
This means that $1 = Rs. 40.
Now let’s say the cost of a McDonald’s Burger in the US is $1 .
This means that for a US resident earning in US dollars, the cost of the Burger in India should be Rs. 40.
Now suppose the rate of inflation in India is 10% while the rate of inflation in US is 0%. Due to this, the cost of the Burger in India would actually be equal to Rs (40x1.1) = Rs. 44. Therefore, although the US resident can buy Rs. 40 for $1, he cannot purchase the Burger for $1 in India.
18. The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country's currency necessary to buy a market basket of goods in the other country, after acquiring the other country's currency in the foreign exchange market, to the number of units of the given country's currency that would be necessary to buy that market basket directly in the given country .There are different kind of measurement for RER.
Thus the real exchange rate is the exchange rate times the relative prices of a market basket of goods in the two countries. For example, the purchasing power of the US dollar relative to that of the euro is the dollar price of a euro (dollars per euro) times the euro price of one unit of the market basket (euros/goods unit) divided by the dollar price of the market basket (dollars per goods unit), and hence is dimensionless. This is the exchange rate (expressed as dollars per euro) times the relative price of the two currencies in terms of their ability to purchase units of the market basket (euros per goods unit divided by dollars per goods unit). If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and GDP deflators (price levels) of the two countries, and the real exchange rate would always equal 1.
The rate of change of this real exchange rate over time equals the rate of appreciation of the euro (the positive or negative percentage rate of change of the dollars-per-euro exchange rate) plus the inflation rate of the euro minus the inflation rate of the dollar.
19. Fixed exchange rate
It is the system of following a fixed rate for converting currencies.
In this system, the government (or the central bank acting on its behalf) intervenes in the currency market in order to keep the exchange rate close to a fixed target.
It does not allow major fluctuations from the central rate.
Advantages
It provide the stability of exchange rate.
Fixed rates provide greater certainty for exporters and importers.
Disadvantages
Too rigid to take care of major upheavals.
Need large reserves to defend the fixed exchange rate.
May cause destabilizing speculations; most currency crisis took place under a fixed exchange system.
20. Floating/flexible exchange rate
Under the flexible exchange rate system, the rate of exchange is allowed to vary to suit the economic policies of the government.
Flexible exchange rates are exchange rates, which fluctuate according to market forces.
The value of the currency is determined solely by the forces of demand and supply in the exchange market.(self correcting mechanism)
Advantages
Automatic adjustment for countries with a large balance of payments deficit.
Flexibility in determining interest rates
Allow countries to maintain independent economic policies.
Permit a smooth adjustment to external shocks.
Don't need to maintain large international reserves.
Disadvantages
Flexible exchange rates are highly unstable so that flows of foreign trade and investment may be discouraged.
They are inherently inflationary.
Managed exchange rate
Managed exchange rate systems permit the government to place some influence on an exchange rate that would otherwise be freely floating.
Managed means the exchange rate system has attributes of both systems.
Through such official interventions it is possible to manage both fixed and floating exchange rates.
22. Determinants of foreign exchange rate
Interest Rate
Whenever there is an increase interest rates in domestic market there will be increase investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.
Inflation Rate
when inflation increases there will be less demand for local goods (decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).
Government budget deficit or surplus
The market usually react negatively to widening govt. budget deficits and positively to narrowing budget deficits. This will result in change in the value of countries currency.
Political conditions
Internal, regional and international political conditions and events can have a profound effect on currency market
23. Theory of Purchasing Power Parity(ppp)
PPP theory measures the purchasing power of one currency against another after taking into account their exchange rate
‘ taking into account their exchange rate’ simply means that you measure the strength on $ 1 with that of Rs. 50 and not with Rs. 1
( assuming the exchange rate is $ 1 = Rs. 50)
Developed by Gustav Cassel ( Swedish economist – 1918) , the theory states that in ideally efficient markets, identical goods should have one price
The concept is founded on the law of one price; the idea that in the absence of transaction costs, identical goods will have the same price in different markets
However, if it doesn’t happen, then we say that purchase parity does not exist between the two currencies
-PPP theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalise prices between countries and change exchange rates in doing so
-Moreover, in the long run, having different prices in the US and India is not sustainable because an individual or a company will be able to gain an arbitrage profit
-Because of arbitrage opportunities, market forces come in to play and bring about an equilibrium in prices
- PPP theory is often used to forecast future exchange rates , for purposes ranging from deciding on the currency denomination of long-term debt issues to determining in which countries to build plants
-The relative version of PPP now commonly used states that the exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price levels of the two countries
-Suppose, inflation is 5 % in the United States and 1 % in Japan, then the dollar value of the Japanese Yen must rise by about 4 % to equalise the dollar price of goods in the two countries
