INSTITUTE OF MANAGEMENT AND STUDIES

MBA (FA) SESSION 2018-2020

ASSIGNMENT REPORT ON

Exchange rate Determination- Challenges and

limitations
International Finance
SUBMITTED BY:- SUBMITTED TO:-
VAIBHAV RAJORE Dr. Amrata Chourasia
(66520)
(SEC-B, 4TH SEM)
 Exchange rate determination - Exploring the Current
challenges and Limitations

Exchange Rate

Foreign exchange rate is the price at which one currency can be converted into another.
It represents the rate at which a firm may exchange one currency for another. Thus, the
exchange rate is simply the amount of a nation’s currency that can be bought at a given
time for a specified amount of the currency of another country.

Example :-

If a Apple seller, sells his goods to a buyer in Kolkata, he will receive in terms of Indian
monetary unit.

This suggests that domestic trade is conducted in terms of domestic currency. But if the
Apple seller decides to travel abroad, he must exchange Indian monetary unit into dollar
or pound or euro.

To facilitate this exchange form, banking institutions appear. Apple seller will then visit a
bank for foreign currencies. The bank will then quote the day’s exchange rate—the rate
at which Indian monetary unit are going to be exchanged for foreign currencies. Thus,
foreign currencies are required within the conduct of international trade.

Foreign exchange market comprises of economic banks, foreign exchange brokers and
authorized dealers and therefore the monetary authority (i.e., the RBI), one currency is
converted into another currency.

A rate is that the rate at which one currency is exchanged for one more. Thus,
an rate may be thought to be the value of 1 currency in terms of another. An rate could
be a ratio between two monies. If 5 UK pounds or 5 US dollars buy Indian goods worth
Rs. 400 and Rs. 250 then pound- rupee or dollar-rupee rate becomes Rs. 80 = £1 or
Rs. 50 = $1, respectively. Exchange rate is sometimes quoted in terms of rupees per
unit of foreign currencies. Thus, an rate indicates external purchasing power of cash.

A fall within the external purchasing power or external value of rupee (i.e., a fall in rate,
from Rs. 80 = £1 to Rs. 90 = £1) amounts to depreciation of the Indian monetary unit.
Consequently, an appreciation of the Indian monetary unit occurs when there occurs a
rise within the rate from the prevailing level to Rs. 78 = £1.

In other words, external value of the rupee rises. this means strengthening of the Indian
monetary unit. Conversely, the weakening of the Indian monetary unit occurs if external
value of rupee in terms of pound falls. Remember that every currency features a rate of
exchange with every other currency.

Exchange rate Determination

There are two methods of exchange rate determination.

One method falls under the classical gold standard mechanism and another method
falls under the classical paper currency system. Today, gold standard
mechanism doesn't operate since no standard unit of measurement is now exchanged
for gold.

All countries now have paper currencies not convertible to gold. Under inconvertible pa-
per currency system, there are two methods of rate determination. the primary is
understood because the purchasing power parity theory and therefore the second is
understood because the demand-supply theory or balance of payments theory. Since
today there's no believer of buying power parity theory, only demand-supply approach
to exchange rate determination are being considered.

Demand-Supply Approach of Foreign Exchange, Or BOP Theory of Foreign Exchange:

Since the exchange rate could be a price, economists apply supply-demand conditions
of price theory within the exchange market. an easy explanation is that the
speed of exchange equals its supply. India and therefore the USA. Let the domestic cur-
rency be rupee. US dollar stands for exchange and therefore the value of rupee in terms
of dollar (or conversely value of dollar in terms of rupee) stands for exchange rate.
Now the worth of 1 currency in terms of another currency depends upon demand
for and provide of exchange.

(a) Demand for foreign exchange:

When Indian people and business firms want to form payments to the US nationals for
buying US goods and services or to present gifts to the US citizens or to shop for assets
,the demand for exchange (in dollar) is generated. In other words, Indians demand or
buy dollars by paying rupee within the foreign exchange market.

A country releases its foreign currency for getting imports. Thus, what appears within
the accounting of the BOP account is that the sources of demand for exchange. The
larger the quantity of imports the greater is that the demand for exchange.

The demand curve for exchange is negative sloping. A fall within the price
of exchange or a fall within the price of dollar in terms of rupee (i.e., dollar
depreciates) means foreign goods are now more cheaper.

Thus, an Indian could buy more American goods at a coffee price. Consequently,
imports from the USA would increase leading to a rise within the demand for exchange,
i.e., dollar. Conversely, if the value of exchange or price of dollar rises (i.e., dollar
appreciates) then foreign goods are going to be expensive resulting in a fall in import
demand and, hence, fall within the demand for exchange.

Since price of exchange and demand for exchange move in other way, the importing
country’s demand curve for exchange is downward sloping from left to right.

(b) Supply of foreign exchange :-

Supply of foreign currency comes from its receipts for its exports. If the foreign nationals
and firms will purchase Indian goods or buy Indian assets or give grants to the govt. of
India, the supply of exchange is generated.

In other words, what the Indian exports (both goods and invisibles) to the
remainder of the globe is that the source of exchange. To be more specific, all the
transactions that appear on the method of accounting of the BOP account are the
sources of supply of exchange.

A rise within the rupee-per-dollar charge per unit means Indian goods are cheaper to
foreigners in terms of dollars. this may induce India to export more. Foreigners also
will find that investment is now more profitable. Thus, a high price or charge per
unit ensures larger supply of interchange. Conversely, an occasional charge per
unit causes charge per unit to fall.

Now we will bring both demand and supply curves together to work out foreign ex-
change rate. The equilibrium rate of exchange is decided at that time where demand
for exchange equals supply of foreign exchange.

Current Challenges & Limitation of Exchange Rate Determination

1. Inflation Rates

Changes in market inflation cause changes in currency exchange rates. a

rustic with a lower rate of inflation than another's will see an appreciation within
the value of its currency. the costs of products and services increase at a slower
rate where the inflation is low. a rustic with a consistently lower rate of
inflation exhibits a rising currency value while a rustic with higher inflation
typically sees depreciation in its currency and is sometimes in the course
of higher interest rates
2. Interest Rates

Changes in charge per unit affect currency value and dollar rate. Forex rates,
interest rates, and inflation are all correlated. Increases in interest rates cause a
country's currency to understand because higher interest rates provide higher
rates to lenders, thereby attracting more foreign capital, which causes an
increase in exchange rates

3. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is said to
current accounts and therefore the balance of payments. If the value of a
country's exports rises by a greater rate than that of its imports, its terms of trade
have favorably improved. Increasing terms of trade shows' greater demand for
the country's exports. This, in turn, leads to rising revenues from exports, which
provides increased demand for the country's currency (and a rise within
the currency's value). If the value of exports rises by a smaller rate than that of its
imports, the currency's value will decrease in reference to its trading partners.

4. Country’s accounting / Balance of Payments

A country’s accounting reflects balance of trade and earnings on foreign

investment. It consists of total number of transactions including its exports,
imports, debt, etc. A deficit in accounting thanks to spending more of its currency
on importing products than it's earning through sale of exports causes
depreciation. Balance of payments fluctuates rate of its domestic currency.

5. Government Debt

Government debt is debt or debt owned by the central government. a rustic with
government debt is a smaller amount likely to amass foreign capital, resulting
in inflation. Foreign investors will sell their bonds within the open market if the
market predicts government debt within a particular country. As a result, a
decrease within the value of its rate will follow.
 6. Political Stability & Performance

A country's political state and economic performance can affect its currency
strength. a rustic with less risk for political turmoil is more attractive to foreign
investors, as a result, drawing investment off from other countries with more
political and economic stability. Increase in foreign capital, in turn, ends up in an
appreciation within the value of its domestic currency. a rustic with sound
financial and national trading policy doesn't give any room for uncertainty in value
of its currency. But, a rustic liable to political confusions may even see a
depreciation in exchange rates.

7. Recession

When a rustic experiences a recession, its interest rates are likely to fall,
decreasing its chances to amass foreign capital. As a result, its currency
weakens compared thereto of other countries, therefore lowering the rate.

8. Speculation

If a country's currency value is predicted to rise, investors will demand more of

that currency so as to create a profit within the near future. As a result, the
worth of the currency will rise thanks to the rise in demand. With this increase in
currency value comes an increase within the rate further.

References
http://www.economicsdiscussion.net/foreign-exchange/foreign-exchange-rate-meaning-and-
exchange-rate-determination/6449

http://www.yourarticlelibrary.com/economics/foreign-exchange/foreign-exchange-rate-concept-
and-types/72309

https://www.investopedia.com/trading/factors-influence-exchange-rates/

https://www.compareremit.com/money-transfer-guide/key-factors-affecting-currency-exchange-
rates/