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# FOREIGN EXCHANGE RATES MECHANISM

DEFINITION:

An exchange rate is the rate at which one country’s currency can be traded in exchange for another
country’s currency.

## SPOT RATE: for immediate delivery.

FORWARD RATE: For delivery to be made in future.

## 1. RATE OF INFLATION BETWEEN DIFFERENT

COUNTRIES S -S = I -I
T O F D

## (THE PURCHASING POWER PARITY S O1+I D

THEORY): Where
St = expected spot rate at time t
Purchasing Power Parity Theory, also So = current lower foreign currency
known as Law of one price theory, holds spot exchange rate at time 0
that over the long term, the average if = expected inflation in foreign
value of the exchange rate b/w two country to time t
currencies depends upon their relative id = expected inflation in domestic

## If a currency has a lower purchasing Moreover growth in MS affects the

power in its own country, it is overvalued. inflation Rate, hence exchange rates.
This will exert a downward pressure in
the local currency. 2. INTEREST RATES BETWEEN DIFFERENT
COUNTRIES:
If a currency has a higher purchasing power
in its own country, it is undervalued. This High interest rates increase foreign
will exert an upward pressure in the local investments, which results in increased
demand for local currency by foreigners
currency.
due to which the exchange rate tends to
NEW EXCHANGE RATE X = OLD EXCHANGE RATE X × increase, but there might be the
[INITIAL / FINAL] RATE OF CURRENCY Y possibilities of devaluation.

This theory is incapable to describe short- Link b/w Interest rates differentials and
term foreign exchange movements exchange rates i.e. International Fisher’s
It is more valid in long run because the Effect, is given by:
interest rate relative to other countries is
certainly a factor, which influences the 1+rf = 1+if
exchange rate. Although this influence is 1+rd = 1+id
obvious, it is not predominant. This is
apparent from the fact that if exchange
rates did respond to demand and supply 3.
for current account items, then BoP on
current account of all countries would
tend towards equilibrium.

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. BALANCE OF PAYMENTS AND EXCHANGE RATE:
II. AS A DESTABILIZING FACTOR:
Elasticity of demand for exports and
elasticity of demand for imports will If speculators create such a high
determine the relation b/w BoP and volume of demand to buy or sell
exchange rates. currency that exchange rate
fluctuates to levels where it is
If there is persistent deficit in BoP, overvalued or undervalued, so
international confidence on currency will speculation can pose a destabilizing
be eroded and causes exchange rate to effect on the health of economy
fall. because uncertainty about the future
exchange rates will deter FDI.
Moreover, the output capacity and the
level of employment in the domestic
economy might influence the BoP, 6. GOVERNMENT INTERVENTIONS IN FOREIGN
because if the domestic economy has full EXCHANGE MARKETS:
employment already, it will be unable to
increase its volume of production for
I. DIRECT MEASURES (OFFICIAL OR
exports
UNOFFICIAL):
5. SPECULATION: • Open Market Operations i.e.
Traders as well as investors of capital
might carry speculation in a currency. II. INDIRECT MEASURES:

## • When a currency is expected to By changing domestic interest rates

devalue, debts are paid slowly in to:
the hope that the exchange rate • Attract financial investment by
may fall, giving an advantage to raising interest rates.
them to pay off their debts, as • Discourage financial investment
currency becomes cheaper. by lowering interest rates.

## • Debtors owing money in a currency,

which is expected to appreciate in
value, may try to pay off their debts
before the currency becomes
expensive, giving them financial

## Speculation may be act:

I. AS A STABILIZING FACTOR:

## In case of deficit, there is

downward pressure. If speculators
considered deficit temporary, they
might purchase assets in the
currency when there is Bop deficit
and sell them, perhaps at a small
profit, when there is surplus.

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EXCHANGE RATES POLICIES OF GOVERNMENTS:

## 1. FIXED EXCHANGE RATES: 3. FREE FLOATING EXCHANGE RATES:

It is a policy of extremely rigid fixed Exchange Rates are left to the free
exchange rates in which every play of market forces and there is no
Government must use its official official financing at all. There is no
reserves to create an exact match b/w need for the Government to hold any
supply and demand for its currency in official reserves, because it will not
the FOREX markets, in order to keep want to use them.
the exchange rate unchanged. Using
the official reserves will thus cancel USAGE:
out a surplus or deficit on the current
account and non-official capital Floating Exchange Rates is the only
transactions in their BoP. option available to the Government
when all other systems break down
• A BoP surplus would call for and fail.
• A BoP deficit would call for 4. MOVABLE PEG:
drawings on official reserves.
A Movable or adjustable peg system is
The official reserves could consist of a system of fixed exchange rates, but
any currency or gold within the FOREX with a provision for the devaluation or
Agreement. revaluation of currency.

## ADVANTAGES OF FIXED EXCHANGE RATE ADVANTAGES OF MARGINS AROUND A MOVABLE

POLICY: PEG SYSTEM:

## i. Removes uncertainty, thus A movable peg system provides

encourage international trade. some flexibility. Exchange rates,
ii. Imposes economic disciplines although fixed, are not rigidly fixed,
on countries in deficit or because adjustments are permitted.
surplus.
DISADVANTAGES OF FIXED EXCHANGE RATE MOVABLE PEG SYSTEM:
POLICY:
It is still fairly inflexible, because
i. This policy restricts Governments only have the choice
independence of domestic b/w a revaluation/devaluation or
economic policies. holding the exchange rate steady.
ii. High inflation forces a country
to devalue in order to make its
5. MARGINS AROUND MOVABLE PEG SYSTEM:
exports competitive and
imports cheaper.
A more flexible Movable Peg system
would allow some minor variations in
exchange rates.
2.

SYSTEM:

## It is the most prevalent exchange rate

system today. In this system, a country
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occasionally intervenes to stabilize its SUMMARY:
currency but there is no fixed or
pronounced parity. DETERMINANTS OF EXCHANGE RATES:
Here, the market forces basically DEMAND AND SUPPLY FOR CURRENCY:
determine exchange rates but
Government buys or sell currencies or 1. RATE OF INFLATION – Purchasing Power
change their money supplies to affect Parity Theory.
their exchange rates.
2. INTEREST RATES – High @i cause high
Sometimes the government leans demand for currency.
against the winds of private markets. At
other times, Government has target 3. BALANCE OF PAYMENT – E/d of X and M
zones, which guide their policy actions. affects BoP through Devaluation
This system is becoming less important
as countries are increasingly gravitating 4. SPECULATION – May be stabilizing or
toward fixed or flexible exchange rates destabilizing; may also practiced by
Through this system, the currency of a 5. GOVERNMENT’S INTERVENTIONS –
country is not allowed to freely float in
the international market or in other • Direct (open market operations);
words, the country adopting this system
or
is not allowed to determine the value of
• Indirect (changing interest
its currency by the free and unfettered
rates).
forces of demand and supply of foreign
exchange.

## This system is adopted by Pakistan on

8th January 1982 and is managed by
SBP.

POLICY:

## 1. Rectify the BoP deficit by falling Ex.

Rate.
2. Prevent BoP surplus by raising Ex.
Rate.
3. Emulate economic conditions in other
countries.
4. To stabilize Ex. Rates for building
confidence of exporters/importers.

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