Reference material for International Finance course for Ex-MBA-2016-17

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The demand of dollars in the rupee dollar market is coming from the Indian
demand for US goods and services. The downward sloping demand curve
indicates that the higher the rupee price of dollar , the more expensive US
goods will be to the Indian buyers, so the smaller the qty of dollar demanded.
Similarly the supply curve is the supply of dollars in the rupee dollar market
and comes from US buyers of Indian goods and services. The upward sloping
curve indicates that as US residents receive more rupees per dollar , they will
buy more from India and hence supply more dollars to the market.
The initial equilibrium point is A, where the exchange rate is Rs 50/$. Now
suppose there is an increase in demand for US products by Indian buyers. This
increased demand will cause demand curve to shift from D1 to D2 ( in fig (i))
and the new equilibrium point will be B at Rs 60/$.
The supply may also change . Suppose that the US starts at point B with a
Rs60/$ exchange rate. If US consumers demand Indian products more than
before, this will result in a supply curve shift from S1 to S2 ( in the fig ii) and
lowers the value of dollar from Rs60/$ to Rs 45 /$.

Stability of the Equilibrium

We also notice that,
if S temporarily falls below 50, an excess-demand for $ is created
This would force $ to rise in value, thus pushing up S
Similarly,
if S temporarily goes above 50, an excess-supply of $ is created
This would force $ to fall in value,thus pushing down S
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Thus, market forces would ensure that S stays at Rs.50 per $ i.e the
equilibrium is a stable equilibrium unless there is a structural shift of the
curve. Function of changes in technology, preferences, competitors. etc.

Equilibrium S Under Fixed System

If India were following a fixed-exchange-rate regime, it can keep S at
whatever level it wants ( forcefully through price controls)
So, India can keep S at 35 (Rupees per $).( to reduce import bills may be
from import of computers)
Sure, at this S, there is an excess-demand for $, but no market force can
increase official S. What will happen ?
black-markets may arise due to pent-up demand, assuming that the
Govt. does not intervene.
Similarly, India can keep S at 60 ( to make their shirts more competitive in
US markets)
At this exchange-rate, there would be an excess-supply of $,
but, again, no market force can reduce the S
Equilibrium S Under Floating System
What if India follows a completely floating regime?
Then, it cannot/ will not change or influence S. The S will
automatically vary as per the market forces
But, what if it follows a managed floating exchange-rate regime?
Then, it can keep S where it wants by intervening in the forex market,
if it has necessary foreign-currency reserve
But, the foreign(US) central-bank can complement or offset this effort.

Exchange Market Intervention

For example, if Indian Govt. wants S at 35, there it would supply the excess-
demand for $ at that rate and the Govt. would have to sell additional $
@Rs.35/$ from its reserves.
Then, Private DEM$ = Private SUP$ + Govt SUP$ (though Private DEM$
Private SUP$)
Anyway, this would lead to an increase in US money supply (=> inflation in
USA) and a decrease in Indian money supply (=> deflation in India)
Sterilized Intervention
To neutralize or sterilize this market intervention, Indian central-bank
can engage in Open market operation:
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buying TBs (for cash rupees) from market and thus putting back the
excess Rs supply that had just been sucked out from the market due
to $ selling.
At the end of the sterilized intervention,
Indian central bank would have less $,(in lieu of selling $)
but no change in domestic money supply.
US central bank can do the reverse:
selling TBs to people (for cash $) to suck out the excess $ supplied in
the mkt ( by Indian Govt) and
thus decreasing the US money supply]
to avoid inflation in US

Advantages and Disadvantages of a floating exchange rate

Advantages :
Automatic balance of payments adjustment :
Any balance of payments disequilibrium will tend to be rectified by a
change in the exchange rate.

For example, if a country has a balance of payments deficit then the

currency should depreciate. This is because imports will be greater
than exports meaning the supply of home currency on the foreign
exchange market will be increasing as importers sell currency to pay for
the imports. This will drive the value of the home currency down.

The effect of the depreciation should be to make your exports cheaper

and imports more expensive, thus increasing demand for your goods
abroad and reducing demand for foreign goods in your own country,
therefore dealing with the balance of payments problem. Conversely, a
balance of payments surplus should be eliminated by an appreciation of
the currency

Freeing internal policy :

With a floating exchange rate, balance of payments disequilibrium
should be rectified by a change in the external price of the currency.
However, with a fixed rate, curing a deficit would require the Govt.
forcefully to bring down the demand for foreign exchange, resulting in
unpleasant consequences for the whole economy such as
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unemployment. ( units relying on imported raw materials for their final
products would suffer).