Session 18

Reading

1.This set of slides

2. Class notes
Exercise

Do you expect a depreciation or an appreciation of the currency, if

a) Foreigners buy stocks of domestic companies

b) A domestic firm establishes a subsidiary abroad
c) Exporters find a new market for their product
d) The country borrows externally
e) Interest charges on foreign borrowings are raised

(everything else remains unchanged)

If you have the choice, where would you like to fix e?
At e1 < e*? Or at e2 > e*?

Or will you not fix e at all?

Overvalued Rupee: e < e*
e
Low import prices S($)
D($)
Low inflation (particularly if
country depends on importable
goods like oil, basic food items
etc.) e*
Excess demand for $
BOP deficit
e1
In case of sustained BOP deficit
fear of devaluation
Money supply falls

$
Undervalued rupee: e > e*
e
D($) S($)
Competitive export prices e2
BOP surplus
Foreign exchange reserves
e*
accumulates
Money supply rises
May cause inflationary
pressures

$
Advantages of a fixed exchange rate regime:

Export market uncertainties arising from price fluctuation can be

partly reduced
Households can plan import spending ahead
Speculation on the currency can be avoided
Advantages of a flexible exchange rate regime:

Insulation form foreign shocks

BOP = 0 always, irrespective of recession or growth in foreign
countries

Money supply autonomy

No BOP deficit. Hence no depletion of reserves.

Determination of exchange rate:
Product market approach
Demand for $s:
Consider a rise in e from 40 to 50
Say the country imports 1 good m e
Import price = $ Pm = $5
As e rises fro 40 to 50, import price
rises from Rs.200 to Rs250
As a result, quantity of imports should 50
fall
40
Import bill in $ falls when e rises from
40 to 50

The import bill (in Rupees) falls with a

rise in e from 40 to 50, if demand $
elasticity of import is high.
The import bill (in $) falls with a rise in
e from 40 to 50, irrespective of
whether the demand elasticity is high
or low.
Supply for $s:
Consider a rise in e from 40 to 50
Say the country exports 1 good x e
Import price = Rs. Px = Rs. 400
As e rises fro 40 to 50, export price
falls from $10 to $8
As a result, quantity of exports should 50
rise
40
The export revenue (in $) rises with a
rise in e from 40 to 50 if demand
elasticity of export is high.
- Supply for $ rises if demand elasticity $
of exports is high
Export revenue in Rs. rises irrespective
of the demand elasticity for exports
 e In a flexible exchange rate regime
D($) e = e*
S($)

Excess supply of $ at e = e* is 0
e*
In a completely flexible exchange
rate regime BOP is always 0

$
 Asset Market Approach
to determination of exchange rate
Consider the following:

You have Rs.1200 which you want to invest in a bond for 1 year.
You can chose a domestic bond or a bond in the US asset market.

Interest rate on the Indian bond = 10%

Interest rate on the US bond = 8%

The current exchange rate is Rs.50 = $1

Qn:
Which bond looks more attractive?
Do you need any other information not given above to make your
choice?
Steps to follow for making the choice:

1. find the return if the money is kept in the Indian Bond.

Return on domestic bond = 10% of Rs.1200 = Rs.120
Rate of return on domestic bonds = R(D) = 10%
2. For finding the return on the US bond, find the $ value of the principal
at the current exchange rate [=1200/50 = $24]
3. Find the $ return after 1 year [= 8% or $24 = $1.92]
4. Convert (return + principal) in Rupees using the expected exchange
rate. [= $(24+1.92)*expected e]
return on foreign bond = [$25.92*expected e Rs.1200]
Rate of return of foreign bond
= R(F) =[$25.92*expected e Rs1200] / principal amount Rs.1200
5. Compare R(D) and R(F) to find your preference.
 For comparing the return you need to know the exchange rate at the
time of maturity.. In this case after 1 year.

One can only have expectation about the future exchange rate.

The return calculated on the foreign bond is expected return. This

return may not be realized.
 Exp. e = 48 Exp. e = Exp. e = 52
50
Interest rate on foreign bonds i* 8% 8% 8%
Rate of change in ex. rate e/e - 4% 0% +4%
Principal $24 $24 $24
Return at 8% rate of interest $1.92 $1.92 $1.92
Principal + return ($) $25.92 $25.92 $25.92
Principal + return (Rs.) Rs.1244.16 Rs.1296 Rs.1347.84
Exp. Return from foreign bond Rs.44.16 Rs.96 Rs.147.84
Rate of return on foreign bond 3.7% 8% 12.3%
Preferred bond domestic domestic foreign
i* + e/e 4% 8% 12%
i*. e/e -.3% 0% .3%
i* + e/e + i*. e/e 3.7% 8% 12.3%
 Principal in RS. = B Principal in $ = B/e

Return after 1 yr in $ = [B/e].i* i* = interest rate on foreign bond

Principal + return in $ = (1+i*)B/e

Principal + return in Rs = [(1+i*)B/e]. e(exp)

Return on foreign bond calculated in Rs. = [(1+i*)B/e]. e(exp) B

Rate of Return on foreign bond calculated in Rs.

R(F) = [[(1+i*)B/e]. e(exp) B]/B
= (1+i*)/e]. e(exp) 1
= e/e + i* + e/e.i*
where e = (expected e e)
Since e/e.i* is very small, it can be ignored
and R(F) = [i* + e/e]
 R(F) = [i* + e/e] R(D) = I
If R(F) > R(D), you invest in foreign bond
If R(F) < R(D), you invest in domestic bond

Suppose R(F) > R(D)

US bonds are more attractive
everyone (citizens and foreigners) switch to foreign bonds
capital outflow from India and capital inflow into US
BOP deficit in India and BOP surplus in US
e rises R(F) falls till it reaches R(D)

Suppose R(F) > R(D)

Indian bonds are more attractive
everyone (citizens and foreigners) switch to domestic bonds
capital outflow from US and capital inflow into India
BOP deficit in US and BOP surplus in India
e falls R(D) falls till it reaches R(F)
 R(D)

Ex. Rate : e

e1 R(D) > R(F)

A
e*

R(D) < R(F)

e2

i Returns
 Asset market equilibrium suggests exchange rate will adjust so that R(D)
= R(F)
That is i =i* + [exp e e] / e
This relation is called Uncovered Interest Parity or UIP.

Uncovered (from risk): the expected exchange rate may vary and hence is
a source of risk.
 Covered Interest parity:
i =i* + [e(F) e] / e
Exp. e is replaced by e(F) or the forward market interest rate.

As forward market interest rate is fixed at the time of purchase of the

bond, no risk exists due to exchange rate fluctuations. Hence the word
covered.