FOREIGN EXCHANGE

Refer pages

Dewet -451/457
University book-M2-87/101
 WHAT IS FOREIGN EXCHANGE
• In our country we pay for our purchase as follows
Coins/notes/cheque/money order/DD etc
If we want to make payment to foreigner in US, the matter
becomes complicated. The American will not accept our
Rupees and we have no dollars with us in India to pay
them. We have to call on our banker to change our
rupees in to dollars and remit them to US party.
• This change of rupees into dollars( or any other
currency) and vice versa is called Foreign Exchange. By
foreign exchange we also mean a reserve or a fund of
foreign currency.
 Rate of exchange
• The rate at which one currency is exchanged for another is called
the rate of exchange.
For example, if one USD exchanges for 45 Indian rupees, then rate
of exchange is
1 USD = 45 Rs
Or 1Re= 1/45=0.22 dollars.
• The rate of exchange expresses the external purchasing power of a
home currency.
• According to Crowther, the rate of exchange ‘ measures the number
of units of one currency which will exchange in the foreign exchange
market for another’
• In the words of Anatol Murad, “ the ratio at which one country’s
currency can be exchanged for another is the rate of exchange
between these two countries”
 Exchange rate determination-

• Mint Parity Theory -gold standard

• Purchasing power parity theory
• Balance of payments theory
 Mint parity theory
• Mint parity theory explains the determination of exchange rate
between the two gold standard countries.
• The exchange rate tends to stay close to the ratio of gold values
• In other words, the rate of exchange between the gold standard
countries is determined by the gold equivalents of the concerned
currencies
• For example, before World War1, both England and America were
on gold standard. The British pound contained 113.0016 grains of
gold and the American dollar contained 23.2200 grains of gold. The
exchange rate between the British pound and American dollar was
determined on the basis of the mint parity and was equal to the ratio
of gold content of two currencies
• 1 pound = 113.0016/23.220 = 4.866 dollars
 Purchasing power parity
• No country today is rich enough to have free
gold standard.
• All countries have paper currencies
• It becomes complex when either both countries
have inconvertible paper currencies or one is on
gold and the other on paper currency.
• In such circumstances, the rate of exchange
between two countries is determined by their
respective purchasing powers.
 Purchasing power parity
• Suppose a bundle of commodities can be
purchased in India for RS 45/= and the
same items can be purchased from US for
1 USD.
• Obviously, the rate of exchange will be
1 USD = Rs 45/=
 BALANCE OF PAYMENTS
THEORY
• Balance of payments is a record of
international payments made due to
various international transactions such as
imports, exports, investments and other
commercial, financial and speculative
transactions. The balance of payments
includes all payments made by foreigners
to the nationals as well as all payments
made by the nationals to the foreigners
• The incoming payments are credits and
outgoing payments are debit.
• Export items ie credit constitute supply of
foreign exchange
• Import items ie debit constitute demand for
foreign exchange
• Exporting countries make supply of foreign
exchange and importing countries make
demand
• When there is deficit in balance of payments
the debit will increase credit – ie demand for
foreign currency will increase. As a result
the rate of exchange will rise (or the
exchange value of domestic currency in
terms of foreign currency will fall )
• When there is surplus in balance of
payments the credit will exceed debit – ie
supply for foreign currency will increase. As
a result the rate of exchange will fall (or the
exchange value of domestic currency in
terms of foreign currency will rise )
 Factors influencing Rate of
Exchange
• There are a number of factors which influence the supply and demand for
international money transfers and foreign exchange . Important among them are
• Trade movements.
• Capital flow
• Granting loans
• Sale and purchase of securities
• Banking operations
• Speculation
• Protection
• Exchange control
• Inflation and deflation
• Financial policy
• Bank rate
• Money standard
• Peace and security
• Political conditions
 Trade movements
• If imports exceeds exports, the demand
for foreign exchange increases and as a
result, the rate of exchange of native
currency will fall and move against native
country
• If exports exceeds imports, the demand
for foreign exchange decreases and the
rate of exchange rises and moves in favor
of the native country
 Capital flow
• Capital flow from one country to another
brings changes in the rate of exchange. If,
for example, capital is exported from
America to India for investment in India,
the demand for India rupee will increase in
foreign exchange market. So the rate of
exchange of Indian rupee in terms of
American dollar will increase.
Sale and Purchase of Securities
• When the residents of a country purchase
foreign securities, the demand for foreign
currency increases. The value of home
currency falls. The rate of exchange
moves against the home currency and in
favor of foreign currency.
 Granting of loans
• If a country gets loans from some foreign
country, the supply of foreign will increase. As a
result, the rate of exchange will move in favour
of home currency and against foreign currency.
• But at the time of repayment of loan or granting
loan to foreign country, the supply of foreign
currency will fall and the rate of exchange will
move against the home currency and in favour
of foreign currency.