Many a time, when we hear in news
that Indian rupee depreciates or
appreciates against US dollar, a common question that arises in the our mind is
‘How are exchange rates
determined?’. Though the fluctuations
appear to be a conundrum they are actually not. In fact they are as much
simple, interesting and natural as any other economics concept. Before a CA
student goes for learning ‘How to account for exchange differences?’ as per AS11
it is essential for him to understand the underlying groundwork.
What are exchange rates?
Every
economy is distinct by itself in terms of every economic feature – be it
inflation or demographics or unemployment or interest rates. Given this
diversity, one rupee in India cannot be equal to one dollar is USA. Because
inflation may be hovering at 6% in India, whereas, it may be doing at 4% in
USA. Thus one currency expressed in terms of another currency is called as
exchange rate. Generally exchange rates refer to nominal exchange rates. When
it is said that 1 USD is equal to Rs 50, it is nominal exchange rate.
But
there is one more exchange rate called real exchange rate. The rate at which
one country‘s goods can be exchanged for another country’s is called as Real
exchange rate. If the cost of burger in India is twice the cost of burger is USA,
then the real exchange rate of Indian burger to US burger can be said as 2. To
make it appear more technical it can be put like this:
RER= Domestic price
* Nominal exchange rate / Foreign price
If 1USD is
trading at Rs 50 and a burger is trading
at Rs 100 in India and 1USD in USA, then the RER would be 100*(1/50)/1
=2 .
Theory
of Purchasing power parity
One popular theory of exchange rate determination is the
theory of purchasing power parity. It is based on the ‘Law of one price’, which
states that a good must sell at the same price everywhere. There remains parity
in the price of the commodity everywhere.
Now
how is this parity related to exchange rate determination? The answer lies in
reverse engineering - Suppose the 1kg of coffee costs Rs50 in India and 1 USD
in USA then the exchange rate is nothing, but 1USD=Rs 50. If the price of
coffee goes to Rs 60 due to inflation in India, then the exchange rate is said
as 1USD= Rs 60. Thus the parity in purchasing power acts as a balancing force
for exchange rate determination.
How
can this parity in purchasing power exist?
Any theory to hold good must justify and satisfy the senses.
The law that says a good must sell at same price everywhere does this job very well.
Let us imagine that USA and India are neighbouring towns. Before we get deeper,
we should ensure that we understand the Law of demand.
If the demand for good goes high,
the availability of the good may stammer to cater everyone’s need. Hence the
manufacturer would increase its price to filter the demand.
If demand goes down, to boost
sales the manufacturer would bring down the price. This is law of demand. Put
in another way, if a good is available in abundance, to get them sold the
manufacturer would bring down their price. If they are in short supply their
price would be increased.
If coffee seeds are traded at Rs 50 in India and Rs 30 in
the neighbouring town of USA, people would purchase coffee from USA and sell it
in India to take advantage of the price difference. When this process continues
at a point of time, the availability of coffee seeds would get strained in USA
due to excess demand for US coffee seeds, which would induce coffee
manufacturers in USA to increase the price of coffee seeds to, say, Rs 40.Whereas
in India, since its supply has increased, price of coffee seeds may go down, to
Rs 40. Thus the price is same everywhere. Thus prices have become equalized.
This process of trading taking advantage of price difference is called as arbitrage.
This kind of reaction happens across the globe to ensure that price of the good
remains the same everywhere thus validating the purchasing power parity.
Dynamics
of Exchange rate
1.
Money supply:
When the money supply increases in the economy, it will
cause the price level to increase. According to the theory of purchasing power
parity, just because the price level has increased in the economy, a USD will
not fetch lesser quantity of goods than what it was fetching earlier. For
convenience sake we shall use the previous example. If the coffee price has
increased to Rs 60 from Rs 50, 1USD will not fetch lesser coffee seeds. It will
fetch the same 1Kg of coffee which it was fetching when the price of the coffee
was Rs 50. This implies 1USD will be equal to Rs 60 after the price rise, which
means the inflation has caused the currency to depreciate.
2. Interest
rates:
This is a key factor in the hands
of central bank of a country to have a control over exchange rates. To
understand this, it is necessary to get a deeper understanding over one more
concept called Capital outflow. Capital outflow refers to the amount of foreign
assets purchased by the economy. Net capital outflow refers to the total amount
of capital owned by the citizens of economy, which is invested outside the
frontiers of the economy less the amount of capital invested inside the
economy by foreign nationals. When the central bank of a country rises the
interest rates – both lending and deposit rates- the citizens of the
country will
a)
Grow hesitant to borrow money from banks
b)
Deposit cash that is inside their bureaus in the
banks as they would fetch more returns.
Foreign Institutional Investors,
who look for abode to park their money, will
a) Find
the banks of the economy as a prospective parking yard. Thus they will park
their foreign currency as domestic currency of the economy in the banks.
Now much of the currency of the economy, whose interest
rates have gone up, would be in the banks of the economy. So the amount
available for transaction outside would be lesser. So forex traders cannot
offer their currency as generously as they were doing. Thus earlier if 1USD had
fetched Rs 60, now it would fetch only Rs 50, which means there, happens an
appreciation of currency. Thus when the interest rates increase, the
currency tend to appreciate.
3. Political
Stability
When there prevails a state of
political turbulence, the investors both outside and inside the country might
lose faith on the economy and may take away their money to park it somewhere
else. This sudden scuttle of the capital out of the country is called as
capital flight. When such an event happens the net capital outflow would
increase meaning excess availability of a country’s currency outside for
transaction purpose. This excess supply causes the currency to depreciate.ie.
if a dollar had fetched Rs 50 so far, since the quantity of INR available for
transaction outside is more now it would cause a USD to fetch more INR, say, Rs
60. Thus a capital flight causes depreciation of the currency.
4. Trade
deficits
If the economy’s import is
greater than export it would cause the current account balance of the economy
to go negative.ie. It would need more foreign currency to settle the trade dues
that it has incurred. So it means that the quantity of the currency, say, INR
available in the transaction flow is high because of their dues. Thus the value
of the currency would depreciate causing the economy to reflect its real
status.
5. Large
debts
If the economy is going to
finance its expenditure through debts and borrowings, the situation would be
called as deficit financing. As the expenditures made are of capital nature such
spending would cause surge in employment level leading to rise in demand thereby
causing increase in price level. Thus deficit financing would cause inflation
in the economy. Due to inflation the value of money goes down. According to the
purchasing power parity, this plunge in the value would cause the currency to
face depreciation.
Types of exchange rate systems
a)
Fixed exchange rate system
Under this system, the value of the currency is fixed. It
would not be allowed to fluctuate in the ways of supply and demand in the forex
market. If the demand for a currency is going to increase, the currency would
not be let to appreciate. The central bank would counter the surge in demand by allowing
more of the currency of the economy to float in the market. This can be done by
buying foreign currency denominated assets for which they have pay through
converting their currency into foreign currency. Thus forcible selling takes
place to counter the demand for their currency. Vice versa happens in case of
depreciation.
b) Floating
exchange rate system
Exchange rates fluctuate daily according
the supply and demand conditions in the forex market. Central bank won’t do
much to control and bridle the exchange rates.
c) Managed
float
In practice, this is popular
method of exchange rate management. Here the exchange rates are allowed to
fluctuate but within a specified band limit i.e. INR may fluctuate any way as
the market determines but between limits of Rs 45 and Rs 55. When market pushes
the value of the currency across this limit the central bank would act upon to
control.
In India manged float is the system of exchange rate management regime.
History of exchange rate
determination
Until 1914 Gold standard was the
exchange rate management regime across the globe, where currencies can be
converted into ounces of gold at the exchange rates prevailing then.
Here the exchange rates are determined as the measure of quantity of gold that
a unit of the nation’s currency could buy. If 100 INR could buy 50grams of gold
and 100 USD could buy 5000 grams of gold, then the exchange rate would be 100USD
per INR.
In 1944, after World War II,
Bretton woods accord was signed by the world countries. It was agreed that US
would maintain the value of 1USD equal to 35 Ounces of gold. Other currencies
were pegged at rates against USD. However they can allow their value of the
currency to fluctuate upward or downward by 1% from the forepegged value. This means that only the dollar
enjoys the benefit of getting fixed quantity of gold in return for a fixed quantity
of their currency. Other countries have to produce an amount of their currency
equal to a dollar to get the said 35 ounce of gold.
Later during the early 1970-s,
following the Vietnam War the US economy faced an economic congestion.
Inflation soared in the US. Net capital outflow from the economy surged. As a
result the country’s currency started losing its value in the world arena. The
countries of the world started losing their faith on dollar. Countries started
redeeming their dollar reserves as gold. France converted their dollar reserves worth $191 Million into gold followed by many other countries. All these jamming finally led the US to end
its gold standard preservation. The then president of US Nixon made
announcement that the dollar can no longer be converted into fixed quantities of
gold. This end of the Bretton woods practice is termed popularly as Nixon
shock.
Since then most of the countries
follow floating exchange rate system, which was formally recognized in the
Jamaican accord of 1978. As at 2002, 76 countries adopted floating exchange
rate regimes and 111 countries adopted fixed exchange rate regimes.
Thus dollar lost its identity as the world
reserve currency. But still dollar stands as major component of foreign
reserves of the countries across the globe (65.7% as of 2007). However the dollar’s
supremacy is questioned with increasing prominence of other currencies like canadian dollar, renminbi etc…
Hope this scribbling would have
given some idea about Exchange rate determination.
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