Exchange Rate Determination

Exchange Rate Determination
8 March 2016
kanishgeorge@gmail.com
Determinants of Exchange Rate

Factors affecting Currency Fluctuations
8 March 2016
Interest Rates
Inflation
Balance of payments
Growth in money supply
Business Cycle
Decline in foreign exchange reserve
Political Situation
PPP Theory
Purchasing Power Parity

Gustav Cassel, Sweden
Abnormal deviations in International Exchange, 1918.
PPP theory measures the purchasing power of one
currency against another after taking into account their
exchange rate.
At any given time, the rate of exchange between two
currencies is determined by their purchasing power.
Absolute version
Relative version
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Assumptions
Law of one price
In the absence of transaction costs, identical goods
will have the same price in different markets.
Free role of arbitrageurs

Arbitrageurs are free to take advantage of any
disparity in prices anywhere in the world.
Unrestricted movement of goods or financial

assets
There are no restrictions for movement of goods and
financial assets across countries.
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Purchasing Power
Purchasing power of a currency is equivalent
to the amount of goods and services that can
be purchased with one unit of that currency.
The theory states that in ideally efficient
markets, identical goods should have one
price.
The exchange rate between two currencies is
determined in such a way that the rate
provides the same purchasing power for both
the currencies.
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Example
If a commodity costs 90 in India and $2 in
USA, the initial equilibrium exchange rate
between the dollar and rupee would be
$2=90
$1=45
If the price of the commodity moves in India
up to 99 on account of 10% inflation, the
exchange rate will adjust to equate the
purchasing power of the two currencies.
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If the exchange rates are not adjusted,

arbitrageurs will operate.
The dollar-rupee exchange rate will move to a
new equilibrium to avoid price disparity or
arbitrage opportunity.
$1= 49.50
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Absolute Version
The exchange rate between the currencies of two
countries would equal to the ratio of the price
levels of the two countries, measured by the
respective consumer price indices.
Current exchange rate e0 =
This explains how the exchange rates between

two currencies are determined; only if the same
commodities are included in the same proportion
in the basket of goods being used for the
calculation of price indices in both the domestic
and foreign countries.
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Relative Version
Explains how the exchange rate between two
currencies fluctuate over the long run.
Theory suggests the inflation as the reason.
The change in exchange rates would equal the
inflation rate differential between the two
countries.
Predicts a relationship between the inflation
rates of two countries over a specified period and
the movement in the exchange rate between
their two currencies over the same period
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The relationship between change in exchange

rate and inflation rate differential is:
where et =
e0=
ih=
if =
t=
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1+
1+
Expected exchange rate at time period t

Current exchange rate
home inflation
foreign inflation
the time period
10
The future expected exchange rate can be

estimated as
= 0
1 +
1 +
The current exchange rate between the US dollar

and the Indian rupee is US$= 43.35. The
inflation Rates in India and the USA are expected
to be 7% and 3% respectively over the next two
years. What would be the dollar-rupee exchange
rate after two years?
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Nominal Exchange Rate

The rate at which you can purchase dollars.
1 US$= 40
To calculate the nominal exchange rate, simply
measure how much of one currency is
necessary to acquire one unit of another.
The amount of currency you can receive in
exchange for another currency.
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12
Real Exchange Rate

Real exchange rates are nominal rates
adjusted for differences in price levels.
The purchasing power of a currency relative to
another at current exchange rates and prices.
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13
Advantage/ Disadvantage
A country with higher inflation will experience
depreciation in the value of currency and vice
versa.
The three assumptions may not be always true.
Other factors such as Interest rates, Govt
interference, BoP etc. may also influence
exchange rates.
Theory ignores capital flows between countries.
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FISHER EFFECT THEORY

Irving Fisher
Fishers Closed Proposition or
Hypothesis.
Varying interest rates in different
countries are due to the inflation
rate differential between the
countries.
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15
Real Interest Rate

Rate of interest required by the
investor as reward for waiting.
Return on investment to the savers.
When there is inflation, the value of
interest would erode.
This interest rate is adjusted towards
inflation to attract investment.
Approximately the nominal interest
rate minus the inflation rate.
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16
Nominal Interest Rate

Interest rate adjusted for inflation.
Required real rate of return on
investment plus the expected rate
of inflation.
Countries with higher rate of
inflation would have higher nominal
rates and vice versa.
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Fisher Effect
1+r = (1+a)(1+i)
R= a+ i+ ai
Where r= nominal interest rate
a= real interest rate required
i= expected rate of inflation
The interest rate differential

between any two countries equals
the inflation rate differential
between these two countries.
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Questions
Required real interest rate is 4 per
cent and the expected rate of
inflation is 10 per cent. Find the
nominal interest rate.
Required real interest rate is 5% and
the expected rate of inflation is
6.5%, Calculate Nominal Interest
rate.
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19
Find real interest rate if nominal

Interest rate is 10 per cent and rate
of inflation is 4 per cent.
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International Fisher Effect Theory

Fishers Open proposition Or
Generalised Version
Combination of PPP theory and
Fisher Effect.
Interest rate differential between
two countries is equal to inflation
rate differential.
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1+,
1+,
1+,
1+,
21
IFE
Exchange rate movement equals the
interest rate differential between the
countries.
Anticipated change in exchange rate
between two currencies would equal
the inflation rate differential between
the two countries, which in turn,
would equal the nominal interest rate
differential between these two
countries.
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22
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1+,
1+,
1+,
1+,
1+,
1+,
1+,
1+,
23
If the interest rate in India is

expected as 9.5% against the
interest rate of 4% in the USA, what
would be the dollar-rupee exchange
rate after one year, given that the
current exchange rate is 1US$=42.
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The inflation rates in India and USA

over the year are expected to be
6.5% and 3% respectively. The
current dollar-rupee exchange rate
is Rs.42.50/USD. The interest is
likely to be 4% in USA. What would
be the expected nominal interest
rate at the year end?
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Interest Rate Parity Theory

The interest rate difference between
two countries is equal to the
percentage difference between the
forward exchange rate and the spot
exchange rate.
Forward rate differential in the
exchange rate of two currencies would
equal the interest rate differential
between the two currencies.
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The return on a currency is the

interest rate on that currency plus
the expected rate of appreciation
over a given period.
When the returns on two currencies
are equal, interest rate parity
prevails.
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The forward premium or discount of

one currency relative to another
should be equal to the ratio of nominal
interest rates on securities of equal
risk and duration denominated in the
two currencies.
1+,
1+,
=
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1+,
1+,
28
1+,
1+,
1=
P= forward premium or discount of

foreign currency
P=
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Example
Interest rate in India and USA are
10% and 6% respectively and the
dollar-rupee spot exchange rate is
Rs.42.50/US$. Calculate 90 day
forward exchange rate, Forward
premium and see whether it
satisfies IRP equation.
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Covered Interest Arbitrage

Borrowing and lending in two markets
and also buying spot and selling
forward the respective currencies so
as to attain parity conditions.
If the forward rate differential is not
equal to the interest rate differential,
covered interest arbitrage will begin
and it will continue till the two
differentials become approximately
equal.
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Uncovered Interest Arbitrage

Does not involve forward market
transactions as interest rate
differential leads to changes in
future spot rate.
If interest rate differential is equal
to changes in future spot rate,
uncovered interest parity will exist.
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Balance of Payment Theory

Demand-supply theory of exchange.
Allen and Kennen, 1978
Exchange rate relates to the position of
balance of payments of the country
concerned.
A favourable balance of payments leads to
an appreciation in the external value of the
currency of the country.
Unfavourable balance of payments causes
a depreciation of the external value.
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Balance of Payment Approach

An increase in domestic price level over
foreign price level makes foreign goods
cheaper.
Lowers export earnings and boosts the
imports.
Demand for foreign currency increases;
domestic currency depreciates.
Lower export leads to lower supply of
foreign currency; foreign currency
appreciates.
Influence on Current account.
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Increase in domestic interest rate

causes greater capital inflow.
Increases the supply of foreign
currency, causes appreciation in
domestic currency.
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Portfolio Balance Approach

McKinnon, 1969.
Based on two financial assets:
Money and Bonds of domestic
country and foreign country.
Wealth = domestic money +
domestic bonds + foreign bonds
Exchange rate establishes an
equilibrium or balance in investors
portfolio.
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Change in real income, interest rate,

risk and price level will influence the
portfolio.
The investor re-establishes the desired
balance in its portfolio.
The re-establishment needs some
adjustments, which in turn, influence
the demand for foreign assets.
Change in demand influences
exchange rate.
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Wealth Effect
Increase in the wealth leads to
demand for foreign assets and there
by to depreciation in domestic
currency.
Increase in risk of foreign assets
leads to decrease in their demand
and appreciation to domestic
currency.
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Monetary Approach
Flexible Price Version
Frenkel (1976)
Exchange rate between two
currencies, is the ratio of their values
determined on the basis of the money
supply and money demand positions.
Demand for money is positively
related with prices and real output.
Negatively related with rate of
interest.
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Any increase in money supply raises

the domestic price level; Increase in
price level lowers the value of
domestic currency.
If increase in money supply is lower
than the increase in real domestic
output, the excess of real domestic
output leads to lowering of domestic
prices which causes an improvement
in value of currency.
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Rise in Interest rate lowers the

demand for money relative to its
supply and causes depreciation in
its value.
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Monetary approach Contd..

Sticky Price version
Dornbusch (1976)
Rise in Interest Rates leads to rise in
supply in money market and thus
currency depreciates.
Rise in Interest rates leads to release
of more money in to money market
by financial institutions, and thus
depreciation in domestic currency.
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Rise in Interest Rate stimulates

capital flow into the country, causes
appreciation of value of domestic
currency.
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Exchange Rate of Rupee

1947-Bretton Woods System- pegged
to gold and pound sterling.
1949- Devaluation of pound sterling
and Indian rupee.
1966- Devaluation against pound
sterling by 57.5%.
1971- Bretton woods system
collapsed, August- December pegged
to USD. Again to Pound sterling in
December.
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1975- Pegged to undisclosed

currency basket.
1991- Rupee devalued by 22%.
1992- Dual exchange rate system
(LERMS) introduced. Official
exchange rate determined by RBI
and a market determined rate.
1993- Market determined exchange
rate system
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1994- Current account convertibility

1997- Tarapore committee
2000- Targeting Capital Account
Convertibility
(Freedom to convert local financial
assets into foreign financial assets
and vice-versa at market
determined rates)
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History and Trends

1950 - 4.79 Indian Rupees to 1 American dollar

1980 - 7.86 Indian Rupees
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2010 - 44 to 50 Indian Rupees
2015 - 63 to 65 Indian Rupees.
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Reasons
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Current Account Deficit

Policy Inaction
Low Forex Reserve
Growth Slowdown
Dependence on foreign money
Recovery in US
Stimulus withdrawal by US
Capital Controls
Trends in other Markets
Speculative Trading
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Convertibility
Currency convertibility refers to the
freedom to convert the domestic
currency into other internationally
accepted currencies and vice versa
at market determined rates of
exchange.
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Types
CURRENT ACCOUNT CONVERTIBILITYallows residents to make and receive
trade related payments.
CAPITAL ACCOUNT CONVERTIBILITYthe freedom to convert the local
financial assets into foreign assets.
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Capital Convertibility
Non-Convertible capital
Cuba(peso) and North Korea(won)
Non participation in FOREX market
Major challenge for domestic currencies there.
Partial Convertible Capital Indian Rupee

RBIs restriction on the inflow and outflow of capital
Full Convertible Capital US dollars

No restrictions or limitation on the amount to be traded
Thus, this is one of the major currency traded in FOREX market
Current Account Convertibility

Economic reforms introduced during
and after 1991
LERMS
Later in 1993 full current account
convertibility was allowed by the
government to provide the full
conversion of foreign receipts on
current account in to Indian rupees.
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Advantages
Encouragement to Exports
Encouragement to import substitution
Incentive to send remittances from
abroad
A self-balancing mechanism
Specialisation in accordance with
comparative advantage
Integration of world economy
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Capital Account Convertibility

Committee on capital account credibility,
set up by RBI(Reserve Bank of India) under
the chairmanship of former RBI deputy
governor S.S. Tarapore.
Economists Surjit S Bhalla, M G Bhide, R H
Patil, A V Rajwade and Ajit Ranade were
the members of the Committee.
The report submitted by this Committee in
the year 1997 proposed a three-year time
period (1999-2000) for total conversion of
Rupee
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Tarapore committee
Reasons for the introduction of CAC in India:
It was meant to ensure total financial mobility in the
country
It also aimed in the efficient appropriation or distribution
of international capital in India
Pre - conditions:
The fiscal deficit needs to be reduced to 3.5% of the GDP
Inflation rates need to be controlled between 3-5%
Non-performing assets (NPAs) need to be brought down
to 5%
Cash Reserve Ratio (CRR) needs to be reduced to 3%
A monetary exchange rate band of plus minus 5% should
be instituted
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The Second Tarapore Committee on Capital

Account Convertibility
Reserve Bank of India appointed the second
Tarapore committee to set out the framework for
fuller Capital Account Convertibility.
The report of this committee was made public by
RBI on 1st September 2006. In this report, the
committee suggested 3 phases of adopting the full
convertibility of rupee in capital account.
First Phase in 2006-7
Second phase in 2007-09
Third Phase by 2011.
Problems
Increase in import prices.
Increase in prices due to increase in
import prices.
If unfavourable BoP, rate will be
high.
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Pre-requisites for Successful

conversion
Maintenance of domestic economic
stability
Adequate foreign exchange reserve
Restrictions on inessential imports
Comfortable current account position
Appropriate industrial policy and
investment climate
Sufficient incentive and strategies for
export growth
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Exchange Rate Determination

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Exchange Rate Determination

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Exchange Rate Determination

Determinants of Exchange Rate

Purchasing Power Parity

Free role of arbitrageurs

Unrestricted movement of goods or financial

If the exchange rates are not adjusted,

Current exchange rate e0 =

This explains how the exchange rates between

The relationship between change in exchange

Expected exchange rate at time period t

The future expected exchange rate can be

The current exchange rate between the US dollar

Nominal Exchange Rate

Real Exchange Rate

FISHER EFFECT THEORY

Real Interest Rate

Nominal Interest Rate

The interest rate differential

Find real interest rate if nominal

International Fisher Effect Theory

If the interest rate in India is

The inflation rates in India and USA

Interest Rate Parity Theory

The return on a currency is the

The forward premium or discount of

P= forward premium or discount of

Covered Interest Arbitrage

Uncovered Interest Arbitrage

Balance of Payment Theory

Balance of Payment Approach

Increase in domestic interest rate

Portfolio Balance Approach

Change in real income, interest rate,

Any increase in money supply raises

Rise in Interest rate lowers the

Monetary approach Contd..

Rise in Interest Rate stimulates

Exchange Rate of Rupee

1975- Pegged to undisclosed

1994- Current account convertibility

History and Trends

1965 - 4.78 Indian Rupees to 1 American dollar

1985 - 12.36 Indian Rupees

Current Account Deficit

Partial Convertible Capital Indian Rupee

Full Convertible Capital US dollars

Current Account Convertibility

Capital Account Convertibility

The Second Tarapore Committee on Capital

Pre-requisites for Successful

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