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TERMINOLOGIES
Foreign Exchange rate
Foreign exchange rate is the rate at which one
currency is exchanged for other.
It is the price of one currency in term of other
The exchange rate between dollar and pound
refers to numbers of dollars required to
purchased one pound
For example if $2.50=1

It means that value of 0.40 pound =$1

Foreign Exchange:
The exchange rate of $2.50=1 or

0.40=$1 will be eliminated in world

market by arbitrage
What is arbitrage:
it refers to the purchase of foreign currency in
one market where its price is low and sell it in
another market where it price is high
The effect of arbitrage is to remove differences
in exchange rate , so that single exchange rate
prevail in world market
If exchange rate is $2.48 in London exchange
market and $2.50 in new York exchange
market

Foreign Exchange:
Arbitrageurs will buy pounds in London and sell
them in new York for earning profit
As a result the price of ponds in term of dollars in
London market rises and falls in the new York
market
This process will end the arbitrage practice

Determination of equilibrium
exchange rate
The exchange rate in a free market is determined by
the demand and supply of foreign exchange
Equilibrium exchange rate is a rate at which demand
for foreign exchange is equal to supply of foreign
exchange
It is the rate which clears the foreign exchange
market
Two method for clearing the market
A) Demand and supply of dollars with price of dollars
in pounds
B) Demand and supply of pounds with price of pounds
in dollarsboth method yields same result

Determination of equilibrium
exchange rate (cont)
1) Demand for foreign exchange
The demand for foreign exchange (pounds) is a derived
from demand from pounds
It arises from import of British goods and services into
U.S and from capital movements from the U.S to Britain
Demand for pounds implies supply of dollars
When U.S businessmen buy British goods and services
and make capital transfers to Britain they create
demand for British pounds in exchange for U.S dollars

Determination of equilibrium
exchange rate (cont)
Demand curve for pounds DD is sloping
downward from left to right
It means that lower the exchange rate on
pounds( pounds became cheaper) (dollars
price of pound) the larger will be demand
for pounds in foreign market
This means that British exports of goods
and services cheaper in term of dollars
The opposite happens if exchange rate on
pounds (dollars price of pound) is higher
It will make British goods and services
dearer

Determination of equilibrium
exchange rate (cont)
Supply of foreign exchange
Supply of foreign exchange in our case is the supply of
pounds
It arises from U.S exports of goods and services to Britain
and capital movement from U.S to Britain
British holders of pounds wish to make payment in $, thus
supply of pounds in market will increase
Supply curve for pounds SS is an upward sloping curve
The relation between exchange rate on pounds (dollar
price of pounds) and supply of pounds is positive
If exchange rate on pounds increases U.S goods and
services become cheaper in Britain ,they would purchase
more and as a result supply of pounds in a market
increase

Determination of equilibrium
exchange rate (cont)
Dollar price of pounds

Exchange rate

R2

R1
S

pounds

Determination of equilibrium
exchange rate (cont)
Given the demand and supply curve for foreign
exchange, the equilibrium exchange rate is determined
where demand for pounds intersects supply of pounds
Equilibrium exchange rate is R and OQ shows
equilibrium demand and supply of foreign exchange
rate
If exchange rate is higher than equilibrium exchange
rate it means that supply of pounds is greater than
demand for pounds
The price of pounds will fall and ultimately equilibrium
exchange rate will reach and economy will come back
to equilibrium point i.e point E

Determination of equilibrium
exchange rate (cont)
An exchange rate lower than equilibrium rate
mean demand for foreign exchange rate is
greater than supply of foreign exchange rate
This leads to increase the price of pounds in
foreign exchange market
so exchange rate will tends to increase and
equilibrium rate will re-established in market

Economy come back to equilibrium point i.e.

point E

Theories of Foreign
Exchange
1:The Mint Parity theory
2: The purchasing Power Parity Theory
3: The Balance of Payments theory

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The Mint Parity Theory

This theory is associated with the working of the
International Gold Standard. (gold standard operated
between 18801914 )
Under this system, the currency in use was made of
gold or convertible into gold at a fix rate. The value
of one currency unit was defined in terms of certain
weight of gold, that is, how many grains of gold is
equal to one dollar or one pound etc.
The central bank of a country was ready to buy and
sell gold at specific price
The rate at which the standard currency of a country
was convertible into gold was called the Mint Price of
gold.
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Explanation of the Theory

The official British price of gold in British was 6
per once and in the US price of gold $36 per
once,
so they were the mint price of gold in respective
countries.
The exchange rate between $ and would be fixed
at $36/6= $6
This rate was called the mint parity or mint par of
exchange because it was based on the mint price
of gold
Thus under the gold standard, the normal rate of
exchange was equal to the ratio of their mint par
values R= $/
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Explanation of Mint Parity

Theory (cont)
But the actual exchange rate could vary above and
below the mint parity due to cost of shipping the gold
between countries
Suppose U.S has deficit in its BOP with Britain
This deficit in BOP will be paid by U.S importer in term
of gold
Suppose the shipping cost of gold from U.S to U.K is 3
cents
So U.S importer will have to pay $6.03 for one pound
This is actual exchange rate

Assumption of the Mint parity Theory

1. It buys and sells gold in any amount at that

price.
2. Supply of money consists of gold or paper
currency which is backed by gold.
3. There is movement of gold between countries
4. Capital is moveable within countries.
5. Price directly varies with money supply

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Criticisms on Mint Parity

Theory
1. The international gold standard does not exist
now ever since after 1930
2. The theory is based on the free buying and
selling of gold and its movement between
countries , while Govt. do not allow such sales or
purchases and movement
3. The theory is fails to explain the determination
of exchange rates as most countries are on
inconvertible paper currencies
conclusion
The mint parity theory has been discarded since
the gold standard broke down now. There are
neither free movements of gold nor gold parities
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The Purchasing Power Parity Theory

(PPP)
The PPP theory was developed by Swedish
economists Gustav Cassel in 1920 to determine
the exchange rate between countries on
inconvertible paper currencies.
This theory states that, the rate of exchange
between two countries is determined by
purchasing power in two different countries
PPP have two versions:
1. The absolute purchasing power parity theory
2. The relative purchasing power parity theory

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PPP Theory

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1) Absolute Purchasing power

parity
The absolute version states that
the exchange rates between two
countries is equal to the ratio of
the price level in the two
countries. The formula is,
R

AB

= PA /PB

where RAB is the exchange rate

between two countries A and B
and PA and PB refers to general
price level in two countries
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Absolute Purchasing power

parity (cont..)
For example if price of one bushel of wheat is $1 in U.S
and 1 in U.K then exchange rate between $ and is
equal to 1
According to the law of one price, a given commodity
should have same price
So purchasing power of two currencies is at parity in
both countries
If the price of one bushel of wheat in term of $ were
$0.50 in U.S and 1.50 in U.K firm would purchase
wheat in U.S and resell it in U.K at profit

Absolute Purchasing power

parity (cont..)
This commodity arbitrage would cause the
price of wheat to fall in U.K and rise in U.S
until the prices were equal to $1per
bushel in both economies
Criticisms
This version is not use because it ignore
the transportation cost and other factors.

2) The Second Version ( Relative

purchasing parity)
According to this version the change in the exchange
rate over a specific period of time should be
proportional to the relative change in price level in the
two nations over the same period of time
The formula used for determination of exchange rate
is
R1 =P1a/P0 . R0

P1b/P0

where R1 shows exchange rate in period 1, and R0 shows

exchange rate in base period
for example if general price level does not change in
foreign nation from the base period to period 1
Where as general price level in the home nation increase
by 50%
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The Second Version ( Relative

purchasing parity)
So according to PPP theory the exchange rate (price of a
unit of foreign currency in term of domestic currency)
should be 50% higher in period 1 as compared to the base
period (home currency depreciated by 50%)
This theory can be explain with the help of other example.
Suppose India and England are on inconvertible paper
standard and by spending Rs.60, the bundle of goods can
be purchased in India as can be bought by spending 1 in
England. Thus, according to PPP, the rate of exchange will
be Rs. 60= 1
Suppose domestic price index increase by 300 and
foreign price index rises to 200 the new exchange rate will
be Rs 60 =1.5

Explanation (PPP)
The exchange rate would be a proper
reflection of the purchasing power in
each country if the relative values
bought the same amount of goods in
each country.

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BOP theory for Determination

of exchange rate
According to this theory ,exchange rate of a
currency is depends one on its BOP position
A favorable BOP raise the exchange rate
And unfavorable BOP reduces the exchange rate
Thus according to this theory exchange rate is
determined by the demand and supply of foreign
exchange
Demand for foreign exchange arises from the
debit side of the balance sheet
Supply of foreign exchange arises from credit
side of balance sheet

BOP theory for Determination

of exchange rate (Cont)
When BOP is unfavorable it means that demand
for foreign currency is more than its supply
It means that external value of domestic currency
in relation to foreign currency fall
Consequently exchange rate to fall..how ?
Suppose RS 60=$1 , external value of domestic
currency is .017
Due to unfavorable BOP Rs90=$1 so external
value of domestic currency is .011
On other hand if BOP is favorable it means that
supply of foreign is greater than demand
It means that external value of domestic currency
in relation to foreign currency rise

BOP theory for Determination

of exchange rate (Cont)
Consequently exchange rate to rise
Suppose RS 60=$1 , so external value of
domestic currency is .017
Due to favorable BOP Rs 40=$1 so external value
of domestic currency is .025
In conclusion, in foreign exchange determination
BOP is important

BOP theory for Determination

of exchange rate (Cont)
price of $ in Rupee

Exchange rate

R2

R1
S

Dollars