PRESENTATION ON:

THEORIES OF EXCHANGE RATE

EXCHANGE RATE:
An Exchange rate is the price of one nations currency in terms of another currency, often termed as the reference currency. When a currency becomes more valuable relative to another currency it is said to be appreciated. The price of the foreign exchange has fallen (e.g. 1 USD buys Rs. 45 instead of Rs. 39 earlier). When a currency becomes less valuable relative to another currency, it is said to be depreciated. The price of the foreign exchange has risen (e.g. 1 USD buys Rs. 39 instead of Rs. 45)

There three theories of exchange rate

1. Balance of Payments theory or demand and supply theory 2. Mint parity theory 3. Purchasing power parity theory

BALANCE OF PAYMENT THEORY

The exchange rate of the currency of a country depends upon its balance of payments. A favourable balance of payments raises the exchange rate, while an unfavourable balance of payments reduces the exchange rate. Thus the theory implies that the exchange rate is determined by the demand for and the supply of foreign exchange. The demand for foreign exchange arises, from the debit side of the balance of payments. It is equal to the value of payments made to the foreign country for goods and services purchased from it plus loans and investments made abroad. The supply of foreign exchange arises from credit side of the balance of payments. It equal all payments made by the foreign country to our country for goods and services purchased from us plus loan disbursed and investments made in this country. The balance of payment balances if debits and credits are equal. If debits exceed credits, the balance of payments is unfavourable. On the contrary, if credits exceed debits, it is favourable. When the balance of payment is unfavourable, it means that the demand for foreign currency is more than its supply. Thus causes the external value of the domestic currency to fall in relation to the foreign currency. Consequently the exchange rate falls. On the other hand, in case the balance of payments is favourable the demand for foreign currency is less than its supply at given exchange rate. This cause the external value of domestic currency to rise in relation to the foreign currency.

BOP:

(X M) + (CI CO) + (FI FO) + FXB = BOP Where: X = exports of goods and services M = imports of goods and services CI = capital inflows CO = capital outflows FI = financial inflows FO = financial outflows FXB = official monetary reserves Financial Account Balance Capital Account Balance Current Account Balance

Credits (Receipts) 1)Current account: a. Export or sale of goods and Services 2) Capital/financial account: a. Borrowing from foreign countries. b. Direct investment by foreign countries. 3) Official Reserve account: a. Increase in foreign holdings through sale gold, foreign currencies.

Debt (Payments) b. Imports of goods and services

c. Lending to foreign countries. d. Direct investment in foreign countries

b. Increase in foreign holdings through purchase of gold and foreign currencies.

MINT Theory
When the currencies of two countries are on metallic standard (gold or silver standard), rate of exchange between them is determined on the basis of parity of minorities between currencies of the two countries. Thus, the theory explaining the determination of exchange between countries which are on the same metallic standard (say gold coin standard), is known the Mint Parity Theory of foreign exchange rate. Thus, the value of each coin (gold or silver) will depend upon the amount of metal (gold or silver) contained in the coin; and it will freely circulate between the countries. For instance, before World War I, England and America were simultaneously on a full-fledged gold standard.

This theory is associated with the working of the International Gold Standard. (Gold standard operated between 18801914) Under this system, the currency in use was made of gold or was exchangeable into gold at predetermined rate. The value of the currency unit was denoted in terms of certain standards of gold that is so many grains of gold to the dollar, the pound, the rupee etc. The central bank of the nation was always prepared to purchase and sell gold at the predetermined rate. The rate at which the measure of money of the nation was exchangeable into gold was termed as the mint price of gold. E.g. If the official British price of gold was 8 per ounce and the US price of gold $ 40 per ounce they were the mint prices of gold in the corresponding nations. The conversion rate between the dollar and the pound would be fixed at $40/8 = $5. This rate was known as the mint equality or the mint par of conversion for the reason that it was based on the mint price of gold.

Therefore under the gold measure the normal or basic rate of conversion was equal to the ratio of their mint par values. However the actual rate of exchange could vary above and below the mint parity by the cost of shipping gold among the two nations, transportation cost and other handling charges, insurance etc. Presume the shipment of gold cost from the US to Britain is 6 cents. So the US importers will have to spend $5.06 to obtain one pound for the reason that he can purchase $5 worth gold from the US treasury and ship it to Britain at a cost of 6 cents per ounce. Assumption of the Mint parity Theory 1. It buys and sells gold in any amount at that price. 2. Supply of money consists of gold or paper currency which is backed by gold. 3. There is movement of gold between countries 4. Capital is moveable within countries. 5. Price directly varies with money supply

Criticisms on Mint Parity Theory 1. The international gold standard does not exist now ever since after 1930 2. The theory is based on the free buying and selling of gold and its movement between countries , while Govt. do not allow such sales or purchases and movement 3. The theory is fails to explain the determination of exchange rates as most countries are on inconvertible paper currencies The mint parity theory has been discarded since the gold standard broke down now. There is neither free movement of gold nor gold parities

PURCHASING POWER PARITY

Purchasing Power Parity (PPP) states that exchange rates between different currencies are in equilibrium when their purchasing power is the same in two countries. This means that the exchange rate between two countries should equal to the ratio of the two countries' relative price levels. If the price level of one country increases (i.e. the country experiences inflation), its currency must depreciate in order to maintain PPP. The basis for PPP is the "law of one price". In the absence of transportation costs and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. The theory of purchasing power parity predicts that a given amount of currency should buy the same quantity of goods in every country. That is, every good should have the same price no matter where it is sold; a concept known as the law of one price. Obviously, when the price of a good changes in one country but not another, this law is tested. The theory predicts that this situation will result in arbitrage. Absolute PPP o Absolute Purchasing Power Parity that is based on the maintenance of equal prices in two concerned countries. o It refers to the equalization of price levels across countries a concept known as the law of one price. Law of one price extended to a basket of goods. o In its absolute form, PPP says that the dollar price of basket of goods in united states is the pound price of the basket in Britain, multiplied by the exchange rate of dollar per pound E.g. Suppose fountain pen in U.S.A. costs U.S. $ 5 and the same in India costs, Rs. 225/- then the exchange rate between Indian Rupee and U.S. Dollar is $1 = Rs. 45.

The exchange rate at which the parity between the purchasing power of two nations is maintained. A change in the purchasing power of any currency will reflect in the exchange rates also. Relative purchasing power parity says that the rate of change of exchange rate is approximately equal to the difference between inflation rates. For example, If Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation differences are large. If India has a higher rate of inflation as compared to country US then goods produced in India would become costlier as compared to goods produced in US. This would induce imports in India and also the goods produced in India being costlier would lose in international competition to goods produced in US. The Relative purchase power parity condition suggests that countries with higher rates of inflation will have a devalued currency.

Assumptions of law of one price are: There is no restriction on the movement of goods between countries. There is no transportation cost involved. There is no transaction cost involved in the buying and selling of goods. There are no tariffs involved.

CASE STUDY: The Big Mac index

An example of one measure of the law of one price, which underlies purchasing power parity, is the Big Mac Index. The Big Mac index was invented by the economist in 1986 as a lighthearted guide to whether currencies are at their correct level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries. The Big Mac Index uses the theory of purchasing power parity to conclude whether a currency is undervalued or overvalued and to predict the direction that the exchange rate will move in the future. The Big Mac Index considers the prices of a Big Mac in McDonald's restaurants in different countries. This index provides a test of the law of one price, but the dollar prices of Big Macs are actually different in different countries. This can be explained by a number of factors. First, transportation costs and government regulations distort the link between prices and exchange rates. Product differentiation also has the same effect. McDonald's changes the characteristics of the hamburger based on the tastes and preferences of the culture in which it is sold. Differentiation makes Big Macs in different countries imperfect substitutes, which decreases arbitrage and weakens the link between prices and exchange rates. Finally, Big Macs are perishable and therefore not easily traded internationally, which represents another barrier to arbitrage. For Example: The average price of a Big Mac in America in July 2013 was $4.56; in China it was only $2.61 at market exchange rates. So the "raw" Big Mac index says that the Yuan was undervalued by 43% at that time.

 Issues

The Big Mac (and virtually all sandwiches) varies from country to country with differing nutritional values, weights and even nominal size differences. Not all Big Mac burgers offered by the chain are exclusively beef. In India which is a predominantly Hindu country beef burgers are not available at any McDonald's outlets. The chicken Maharaja Mac serves as a substitute for the Big Mac. There is a lot of variance with the exclusively Beef "Big Mac": the Australian version of the Big Mac has 22% less energy than the Canadian version, and is 8% lighter than the version sold in Mexico. On 1 November 2009, all three of the McDonald's in Iceland closed, primarily due to the chain's high cost of importing most of the chain's meat and vegetables from the Euro zone. At the time, a Big Mac in Iceland cost 650 krona(ISK) ($5.29), and the 20% price increase that would have been needed to stay in business would have increased that cost to 780 krona(ISK) ($6.36). Fish and lamb meat is produced in Iceland, while beef must be imported. One other example is that Russia has one of the cheapest Big Macs, at the same time as Moscow usually is near the top on lists of costs for visiting business people. Standard food ingredients are cheap in Russia, while restaurants suitable for business dinners with English speaking staff are expensive.