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DEFINITION:
An exchange rate is the rate at which one country’s currency can be traded in exchange for another
country’s currency.
THEORY): Where
St = expected spot rate at time t
Purchasing Power Parity Theory, also So = current lower foreign currency
known as Law of one price theory, holds spot exchange rate at time 0
that over the long term, the average if = expected inflation in foreign
value of the exchange rate b/w two country to time t
currencies depends upon their relative id = expected inflation in domestic
purchasing power. country
This theory is incapable to describe short- Link b/w Interest rates differentials and
term foreign exchange movements exchange rates i.e. International Fisher’s
It is more valid in long run because the Effect, is given by:
interest rate relative to other countries is
certainly a factor, which influences the 1+rf = 1+if
exchange rate. Although this influence is 1+rd = 1+id
obvious, it is not predominant. This is
apparent from the fact that if exchange
rates did respond to demand and supply 3.
for current account items, then BoP on
current account of all countries would
tend towards equilibrium.
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. BALANCE OF PAYMENTS AND EXCHANGE RATE:
II. AS A DESTABILIZING FACTOR:
Elasticity of demand for exports and
elasticity of demand for imports will If speculators create such a high
determine the relation b/w BoP and volume of demand to buy or sell
exchange rates. currency that exchange rate
fluctuates to levels where it is
If there is persistent deficit in BoP, overvalued or undervalued, so
international confidence on currency will speculation can pose a destabilizing
be eroded and causes exchange rate to effect on the health of economy
fall. because uncertainty about the future
exchange rates will deter FDI.
Moreover, the output capacity and the
level of employment in the domestic
economy might influence the BoP, 6. GOVERNMENT INTERVENTIONS IN FOREIGN
because if the domestic economy has full EXCHANGE MARKETS:
employment already, it will be unable to
increase its volume of production for
I. DIRECT MEASURES (OFFICIAL OR
exports
UNOFFICIAL):
5. SPECULATION: • Open Market Operations i.e.
selling or buying of currency.
Traders as well as investors of capital
might carry speculation in a currency. II. INDIRECT MEASURES:
I. AS A STABILIZING FACTOR:
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EXCHANGE RATES POLICIES OF GOVERNMENTS:
It is a policy of extremely rigid fixed Exchange Rates are left to the free
exchange rates in which every play of market forces and there is no
Government must use its official official financing at all. There is no
reserves to create an exact match b/w need for the Government to hold any
supply and demand for its currency in official reserves, because it will not
the FOREX markets, in order to keep want to use them.
the exchange rate unchanged. Using
the official reserves will thus cancel USAGE:
out a surplus or deficit on the current
account and non-official capital Floating Exchange Rates is the only
transactions in their BoP. option available to the Government
when all other systems break down
• A BoP surplus would call for and fail.
additions to the official reserves.
• A BoP deficit would call for 4. MOVABLE PEG:
drawings on official reserves.
A Movable or adjustable peg system is
The official reserves could consist of a system of fixed exchange rates, but
any currency or gold within the FOREX with a provision for the devaluation or
Agreement. revaluation of currency.
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