Business

Environment
B.N. Ghosh

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Chapter 30
Exchange Rate
Environment

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Learning Objectives
The meaning of exchange rate
The determination of equilibrium exchange rate
Theories of foreign exchange rate
The causes of fluctuations in exchange rates
The differences between fixed and flexible
exchange rates
The features, objectives, merits, demerits, and
methods of exchange control
The different exchange rate practices
The concepts of forward exchange market,
nominal and real exchange rates, and Euro
currency
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Meaning of exchange rate

The rate at which the currency of one
country is exchanged for the currency of
another country
is called the rate of foreign exchange.
It should be noted that exchange rate is not
always constant.
It goes on changing from time to time on
account of changes in the demand of and the
supply of foreign
currency.
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Determination of equilibrium
exchange rate

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Determination of equilibrium
exchange rate
Just as the price of a commodity is
determined by its demand and supply in the
market, similarly, the price of a currency is also
determined by the demand for and
the supply of that currency in the foreign
exchange
market.
The supply
of dollars in the foreign exchange
market will come from the exporters who have
sold their commodities in the USA.
It is instructive to note that fluctuations in
the domestic
exchange rate and its continuous fall
ultimately may
leadUniversity
to currency
crisis
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Theories of foreign exchange

rate

Mint Par Theory

urchasing Power Parity Theory

Balance of Payments Theory of Exchange

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Balance of payments theory

of exchange rate
determination
The demand for a foreign currency arises out
of the necessity of purchasing foreign goods,
or making payment to foreign countries or
making investment, or for repayment of debts.
When the balance of payments is
unfavourable, the country will have a weak
exchange rate position, but the exchange rate
position will be strong if the country has a
favourable balance of payments.
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Causes of fluctuations in
exchange rate
Political instability produces lack of confidence not
only for a country but also for its currency. Loss of
confidence in a particular currency results in the
transfer of money from that country to some other
country.
Whenever a country is entitled to receive money on
current account, the demand for its currency increases
and the external value of the currency (exchange rate)
goes up. In the opposite case, when the country has a
debit balance in the current account, its exchange rate
will fall.
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Fixed vs flexible exchange

rates
Both these exchange rates have their merits
and demerits.
The best method will be to have a system
that permits a country to have a rate of
exchange that is not fully fixed but can be
changed within certain well-defined limits.
This means that the requirement should be a
system of flexible exchange stability of the
type provided by the IMF.
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Exchange control
Under this system, the government
and the central bank keep the exchange
rate fixed at a
particular point of time.
They control the forex market and no
transaction involving an exchange can
be settled without the permission of the
governmentcentral bank.
Exchange control system was adopted
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Features of Exchange
Control
There is complete control over the use of

forex.
Imports are regulated.
The exporters have to surrender their forex to
the monetary authority.
The government determines the rate of
exchange. The rate of exchange is not flexible.
Forex can be used only by the license holders.
Forex is allocated by the government or
central bank in priority lines.
Some types of transactions are not permitted.
Directions are given for the use of forex.
The value of each type of foreign transactions
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Exchange rate practices

Adjustable Peg
Crawling Peg
Managed Floating
Arbitrage Operations

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Forward exchange market

A forward exchange market is one where
contracts are made to supply currencies at
fixed dates in the future at fixed prices.
In the forward exchange market, currencies
are bought and sold for transacting at some
future date.
The forward exchange market is a part of
overall forex
market.
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Forward exchange market

Forward exchange market has two parts:
(i) Spot market and (ii) Forward market.
() In the spot market, forex are purchased and
sold on the spot at the prevailing market rate.
() The forward market or the future exchange
market refers to the market where
agreements are made to supply foreign
currency at some future date at a price agreed
now.
() The rate at which forward exchanges are
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Nominal and real exchange

rates

The nominal exchange rate (NER) is

the exchange rate between two
currencies.

RER = NER X
This rate is not relevant in the
exchange of goods and services
between two countries (Mankiew
2008 ).
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The Mundell-Fleming
Model
The MundellFleming model introduced by
Robert Mendel and Marcus Fleming (Sills and
Merton 1991 ) became popular in the 1960s to
explain fluctuations in income, and the
workhorse is still being used for decisionmaking. Basically, the model is an extension of
the conventional ISLM (fiscalmonetary)
framework.
The model states that it is practically
impossible for a country to have a fixed
exchange rate regime, full capital mobility, and
an independent
monetary policy at the same
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Euro currency
Euro currency is any currency that is
deposited by a company, government,
or individuals in banks outside the
domestic economy.
Generally, there are four major
currencies that are being increasingly
used as Euro currency.
These are American dollars, the British
pound sterling,
euro,
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Demerits of Euro
Markets
As there is no government
guarantee, these

markets are less secure for the depositors. There

is nothing like deposit insurance. However, the
markets are working well, and so far, no major
untoward incident has been reported
internationally.
These markets are exposed to forex risks as
compared to domestic institutions. This is so
because these markets have no linkages with the
domestic currency.
In the absence of government control and strict
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