International Economics >> Determination of Exchange Rate
Determination of Exchange Rate
What is exchange rate?
The exchange rate is essentially the price of a currency in terms of another currency. More precisely, exchange rate is the rate at which currency of a country is bought and sold against the currency of another country in the foreign exchange market. For example, selling price of one unit of some foreign currencies in terms of Indian rupee was quoted on the 27th May 1998 as follows: US dollar = Rs. 41.80; UK £ = Rs. 68.05; DM = Rs. 23.75; F Fr = Rs. 7.15; HK $ = Rs. 5.40; Lira (100) = Rs. 2.35; Yen (100) = Rs. 30.30. These rates imply that foreign exchange dealers will sell these currencies at these quoted rates. Buying rates are lower than the selling rates by the amount of dealer's margin.
How is the foreign exchange rate determined? There is no simple answer to this question. For, the method of exchange rate determination has been changing from time to time. It also depends on whether foreign exchange market is free or controlled and whether the government adopts fixed or flexible exchange rate policy. In this chapter, we will discuss first the determination of exchange rate in a free market. This will be followed by a brief discussion on some classical and neo-classical theories of exchange rate determination. Whether exchange rate should be determined by the market or should it be fixed by the government has been a controversial issue. In practice, most countries have adopted both free and flexible exchange rate policies at some stages of their economic growth. We will, therefore, discuss the fixed vs. flexible exchange rate controversy.
Determination of exchange rate in free market
The free exchange market refers to a market in which there is no restriction on the foreign exchange dealings. The government does not intervene with the process of exchange rate determination; rather, it helps the exchange rate to be determined by the market forces by allowing free sale and purchase of foreign exchanger Furthermore, foreign exchange market does not refer to a particular place, but to the facilities provided by the bankers, brokers and other specialised institutions which deal in foreign exchange. The foreign exchange market for a currency may be spread over all the countries in which its buyers and sellers are spread.
As mentioned above, exchange rate is the price of one currency ill terms of anther, or the rate of exchange is the rate at which one currency is exchanged for another. Since rate of exchange is a price, like all other prices, it is determined in a free market by the market forces viz., demand and supply conditions. The demand for and supply of foreign exchange are composite demand and supply. The demand for foreign exchange is derived from the demand for foreign goods and services. It is thus composite of demand for the various kinds of commodities; a variety of services and a wide range of securities. In addition, the other kind of demand comes from the speculators and the monetary authorities willing to build up their foreign exchange reserves for future payment. Similarly, supply of foreign exchange is derived from a composite supply of a variety of goods, services and securities. In addition, foreign exchange supply comes also from speculators, foreign exchange dealers and the monetary authorities trying to get rid of their excess foreign exchange reserves.
To explain the determination of exchange rate in a free market, let us first derive demand and supply curves for foreign exchange. The demand curve for foreign exchange is derived from the demand for foreign goods, services and securities, and shows inverse relationship between exchange rate and demand for foreign exchange as shown by DD1 in Fig. 16.1. In fact a lower exchange rate implies lower prices of foreign goods and services and vice versa. As the law of demand states, the lower the exchange rate, the higher the demand for foreign goods and services, given the domestic comparable prices, and hence the greater the demand for foreign exchange.
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