CA Course

Paper No. 8B - Economics for Finance

EXCHANGE RATE & ITS
ECONOMIC EFFECTS
Dr C Anirvinna

Exchange rate
At the end of this unit, you will be able to:
o Why there is a need for exchange rate?
o Define exchange rate and how it is determined
o Appraise different types of exchange rate regimes
o Describe the functioning of the foreign exchange market
o Explain changes in exchange rates and their impact on the real
economy
Exchange rate
 The need for the study of exchange rate arises due to the fact each
country has their own currency
 When goods/services (even debt repayment) needed to be purchased
there is a need for a common currency.
 The exchange rate for a currency is determined on daily basis
 $US is the supreme currency in the world for stability its maintained.
 Each country will try to determine the value of their currency in terms
of world
 The following example will make it all clear
Exchange rate
 US car costs =$ 10,000
 Indian car costs = Rs 960,000
 To compare the prices of 2 cars we have to convert them into a
common the prices of 2 cars we have to convert them into a common
currency
 Assume 1$ =Rs 48 in this case
 Then US car costs 10000x48 = 480,000
 Indian car costs =960,000
 US car costs just half the price of Indian car and we can exchange 2
US cars for 1 Indian car

Exchange rate
• Exchange Rate : at which currency of one country gets exchanged with currency
of other country. Two variants Nominal vs Real Exchange rate.
• Nominal Exchange Rate : How many units of domestic currency is required to buy
one unit of foreign currency. Rs 75 required to buy 1 USD
• Real Exchange rate: It is the relative prices of goods and services in both
domestic and foreign country. It is the rate at which goods are traded between
two countries.

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐸𝑥𝑐𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑒 𝑋 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑔𝑜𝑜𝑑𝑠

𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑔𝑜𝑜𝑑𝑠

• Real Exchange Rate (E) =

𝑒 𝑥 𝑝

𝑝∗
• =

• If real exchange rate is high means: Answer me

Exchange rate
• If real exchange rate is high means: Price of foreign goods is cheaper than price
of
domestic goods and services. This means Imports of G &S will raise and exports
will fall leading to Nx will be negative resulting in Current account deficit
(CAD)
• If real exchange rate is low means opposite that is Nx will be positive and
Current
Account Surplus

• REAL EXCHANE
RATE CURRENT
ACCOUNT

High Deficit
Low surplus

Exchange rate
 Thus Real exchange rate depends upon the
 Nominal Exchange rate
 Ratio of price level

Nominal Exchange rate

𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑔𝑜𝑜𝑑

𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑑𝑜𝑒𝑚𝑠𝑡𝑖𝑐 𝑔𝑜𝑜𝑑

Nominal exchange rate =Real exchange rate x

DIRECT QUOTE VS INDIRECT QUOTE

 In trading terminals two kinds of exchange rate can be seen namely direct quote
and indirect quote.
 In direct quote when a unit of foreign currency (say $ US) is expressed in terms
of units of domestic
currency (local currency say Rs).
 Under direct method foreign exchange rate is derived by keeping foreign currency
constant and rate is
expressed in number of units of domestic currency
 If 1$US =75 rupees would be a direct exchange of US $ in India.
 In direct quote a lower exchange rate implies the domestic currency (Rs) is
appreciating
 In indirect quote when one unit of domestic currency is expressed in terms of
as units of foreign currency.
Under this indirect method foreign exchange rate is derived by keeping domestic
currency constant and rate
is expressed in number of units of foreign currency
 .If Rs1 = 0.0135 $US or Rs 100 =1.3513 $ US
 indirect quote is the opposite reciprocal of a direct quote, a lower exchange
rate implies that foreign
exchange rate is appreciating
Real Effective Exchange Rate and Cross Rate

Real Effective Exchange Rate

The Real Effective Exchange Rate (REER) is an indicator of external
competitiveness of a
country ‘s currency . It is the weighted average of country’s currency against a
basket of
other major currencies (after adjusting for inflation differentials)
An increase in REER implies that exports become more expensive, and imports
become cheaper; therefore, an increase indicates a loss in trade competitiveness
and vice versa
Cross Rate
Generally, all countries currencies are priced in $ US
Any exchange rate if does not involve the $US then it is called cross rate
AUDNZD, EURJPY, EURGBP
Exchange rate regimes
• An exchange rate regime is the system by which a country manages its currency
with respect to
foreign currencies. . There are two major types of exchange rate regimes at the
extreme ends;
namely:
• Fixed vs Flexible/ Floating exchange rates
• Fixed Exchange rate : If the Value of the currency is pegged against US Dollar
by the Government of
the country.
• The value will not change frequently but value changed by the Government as and
when required but
not to the extent of actual requirement.
• These countries keep value of currency artificially low so that their exports
remain high. Very few
countries follow Fixed Currency.
• Example It is used by China. 1 Yuan = 0.50 USD.
• in order to maintain the exchange rate at the predetermined level, the central
bank intervenes in
the foreign exchange market. It will sell the $ if the value is lesser and vice
versa if the value is higher

Examples for countries follow Fixed, Flexible/Floating

Exchange Rate

 Countries follow fixed exchange rate system

Fiji, Kuwait, Morocco, and Libya & China
 They pegged their currency against basket of currencies. Where as China pegs
their currency against US$
Barring a few countries almost all countries follow flexible/floating exchange
rate
system
DEVALUATION /REVALUTION vs
CAUSES OF FISCAL DEFeICpIT reciation and Appreciation
Persistent Revenue Deficit
Lack of Revenues
Country is iDn EdeVvAeLloUpiAngT IsOtaNte Vs REVALUATION
2. CONSE
cQoUuEnNtrCieEsS w OhFic FhI SfoCllAoLw D fiExFeIdC IeTx change rate if they
deliberately reduce the value of
1. Downgrading of the economy (Moody, S&P etc.).
currency then it is called devaluation .
2. Capital Flys Once they downgrade the economy, the capital will fly (FIIs) out of
country.
3. Rupee D
Oenp rtehceia otiothne Trh hisa mnde a inf sc oruupneteri edesp inreccrieataiosne
dthuee tvoa eluxece osfs csuurprpelny coyf ItNheRn. it is called revaluation.
4. Expensive Imports & Cheaper Exports This means imports of goods and services
becomes costly/expensive and
It happens with the intervention of the government
exports of goods and services become cheaper (competitive).
DEPRECIATION Vs APPRECIATION

CLASS 15 C0o8/u0n1t/r2ie02s0 w hich follow flexible exchange rate system their
currency may get
5. Inflation dIfe Rpurepceiea dteedp roerc iaptepsr,e Icmiapotertds aogf oaiiln
bsetc tohme eU eSx p$e.n Ist ivhea paps eonil sp rwiciethso guot ucpe.n Ittr gael
tb raenflekc itnetde rinv eCnPtIio (nC onsumer
Price Index for Inflation). CPI will raise. This means inflation.
6. Repo Ra te RBI will increase the Repo Rate to control the inflation. This will
lead to fall in investment -> Fall in output
-> Fall in employment -> Fall in income -> Fall in Government Revenues -> Further
increase in fiscal deficit

Exchange rate regimes

• In reality majority of countries follow flexible/floating exchange rate where
in exchange rate is determined
by the market forces of demand and supply.
• But in case the exchange rate deviates the band ( say Rs 70 -75 ) and if it
becomes 76,77,78 then it is
called depreciation on the other hand if it becomes 69,68, 67 then it is called
rupee appreciation) then RBI
will intervene then it is soft peg exchange rate policy
• Hard peg exchange rate policy refers to that a country follows fixed exchange
rate and keeps the value
unchanged. The central bank will intervene only when as and when required
• Advantages of Fixed Exchange rate
1. A fixed exchange rate avoids currency fluctuations and eliminates exchange rate
risks and
transaction costs that can impede international flow of trade and investments
2. A fixed exchange rate can thus, greatly enhance international trade and
investment
3. A reduction in speculation on exchange rate movements if everyone believes that
exchange
rates will not change or stable

Exchange rate regimes

4. A fixed exchange rate system imposes discipline on a country’s monetary
authority and therefore
is more likely to generate lower levels of inflation
5. Exchange rate peg can also enhance the credibility of the country’s monetary-
policy.
6.The government can encourage greater trade and investment as stability more
encourages
investment
• Flexible Exchange rate system
• If exchange rate system is determined by market forces of demand and supply
then it is called
flexible or floating exchange rate system. Majority of the countries follow
flexible exchange rate
system which is considered to be efficient and transparent .
• Advantages of Flexible exchange
1. It allows central bank to follow its independent Monetary policy
2. Floating exchange rate regime allows exchange rate to be used as a policy tool:
for example,
policy-makers can adjust the nominal exchange rate to influence the competitiveness
of the
tradable goods sector
Exchange rate regimes
3. As there is no obligation or necessity to intervene in the currency markets,
the
central bank is not required to maintain a huge foreign exchange reserves (In
reality this is not true every central bank needs FERs).
4. However, the greatest disadvantage of a flexible exchange rate regime is that
volatile exchange rates generate a lot of uncertainties in relation to
international
transactions and add a risk premium to the costs of goods and assets traded
across borders.
5. In short, a fixed rate brings in more currency and monetary stability and
credibility; but it lacks flexibility. On the contrary, a floating rate has greater
policy
flexibility; but less stability

The Foreign Exchange Market

 The foreign exchange market or forex market or currency market is over
counter global market place that determines the exchange rate for currencies
around the world.
The participants are central banks, commercial banks, governments, foreign
exchange Dealers, MNCs that engage in international trade and investments,
non-bank financial institutions such as asset-management firms, insurance
companies, brokers, arbitrageurs and speculators
 The role of central bank is to take care of exchange rate of their respective
currency to
ensure appreciation or depreciation are happening at the desired limits. Both
appreciation and depreciation cause havoc on the national income hence need for
stable currency’
The Foreign Exchange Market
 The commercial banks participate in the foreign exchange market either on their
own account
or for their clients. When they trade on their own account, banks may operate
either as
speculators or arbitrageurs/or both. The bulk of currency transactions occur in the
interbank
market in which the banks trade with each other.
 Foreign exchange brokers participate in the market as intermediaries between
different dealers
or banks.
Arbitrageurs make profit by discovering price differences between pairs of
currencies with
different dealers or banks.
 Speculators, who are bulls or bears, are deliberate risk-takers who participate
in the market to
make gains which result from unanticipated changes in exchange rates.
 Other participants in the exchange market are individuals who form only a very
insignificant
fraction in terms of volume and value of transactions
 Regardless of physical location, and given that the markets are highly
integrated, at any given
moment, all markets tend to have the same exchange rate for a given currency. This
phenomenon occurs because of arbitrage

The Foreign Exchange Market

In the foreign exchange market, there are two types of
transactions:
1) current transactions which are carried out in the spot market
and the exchange involves immediate delivery, as per current
exchange rate
2) future transactions wherein contracts are agreed upon to buy
or sell currencies for future delivery which are carried out in
forward and/or futures markets

The Functions of Foreign Exchange Market

 High Liquidity
It is the most liquid financial market in the whole world involving trading of
various
currencies of the world
Market Transparency
Traders have complete access to the market information of different market
currencies
 Dynamic Market
It is the dynamic market since the value of currency keeps changing on every second
and
hour
 24 hours
It operates 24 hours to facilitate the trade among traders at any time
Determination of Nominal Exchange Rate
• WHY Individuals, Institutions and government DEMAND US DOLLARS?? (DEMAND)
• Foreign Education (for paying university fee)
• Foreign Direct Investment (FDI) (Long Term) (Equity)
• FII (Equity and Bonds)
• Tourism
• Buying Foreign Goods and Services
• Imports
• HOW Individuals/ institutions/ government GET US DOLLARS?? (SUPPLY)
• Exports of goods and services
• Tourists visiting India
• FII (Equity and Bonds)
• FDI
Determination of Nominal Exchange Rate
Changes in exchange rate- Home
currency Depreciation
Changes in exchange rate- Home currency
appreciation

Depreciation or Appreciation of currency

and Dirty Float
Why depreciation or Appreciation of currency are both bad for a currency.
• Why is appreciation bad?? Exports will become expensive (uncompetitive) and
Imports
become cheaper. When Imports g&s more than Exports g &s (M>E), this leads to
Current
Account Deficit.
• Why is depreciation bad?? Exports become cheaper and Imports become costly. When
Exports g&s more than Imports g & s (E>M), this may lead to Current Account
Surplus.
• Both CAD and CAS are bad for the economy. CAD will lead to rupee depreciation and
CAS
will account rupee appreciation.
Dirty Float
In reality many countries follow flexible exchange rate system but what they follow
is dirty
float.
RBI creates band 72-76

FACTORS DETERMINING THE EXCHANGE

RATE
1. CAPITAL FLOWS
• Everyday capital is moving from India to other countries (say USA) and vice
versa. Capital means
FIIs. FDI is Long Term Investment and hence FDI doesn’t move fast unlike FIIs.
• Assume Capital coming into India (Capital inflows) is more than the capital
flowing (Capital
outflows) out of India. Rupee gets appreciated. If Capital outflows are more than
capital inflows,
rupee depreciates.

2. PURCHASE POWER PARITY

• Example: 1 Pound Sterling = INR 80 /-
• Assume one pair of branded shoes cost Rs. 400 /- in India. Same shoes should cost
5 Pound
Sterling in UK. Whether we purchase shoes in India or UK, cost should be the same.
In case shoe
price is 3 UK pounds. Indians would buy more from UK. Pound would appreciate and
Rupee
depreciate.

FACTORS DETERMINING THE EXCHANGE

RATE
3. SHORT TERM INTEREST RATE (REPO RATE)
• If Repo rate in India is higher than Short Term Interest Rate in USA. Investors
are going to take their money out of US
Market and park their money in India in form of bonds and equity. Then, rupee value
appreciates and US $ will appreciate
4. INFLATION
• If inflation rate in India is higher than US Dollar. There is a possibility that
capital may fly from India to USA.

5. FISCAL DEFICIT
• If Fiscal deficit is high for any country, credit rating agencies in USA like S&P
will downgrade the economy. Investors will
take their money out of the country. Rupee value depreciates.

6. CURRENT ACCOUNT DEFICIT

• Imports of Goods & Services more than Exports. Credit Rating agencies in USA like
S&P will downgrade the economy.
Investors . Both Fiscal Deficit and Current Account Deficit is called Twin Deficit
Problem.

IMPACT OF EXCHANGE RATE

FLUCTATIONS ON INDIAN ECONOMY
1. It plays a major role in international trade of exports and imports.
Appreciation of currency
may hurt exports and benign on imports
2. if currency depreciates the exports may become cheaper and competitive in the
world market
which may be counter balanced costlier exports due to depreciation of rupee
3. If currency depreciates the cost of repayment of debt of corporates and
government will go up
4. If currency depreciates the cost of imported raw materials and inputs would go
up for
developing /under developed countries resulting increased in cost of production
fall in real
output
5. If currency depreciates the cost of two major imports namely oil and gold will
go up for a
country like India.

IMPACT OF EXCHANGE RATE

FLUCTATIONS ON INDIAN ECONOMY
6. If currency depreciates then the price of foreign goods may become expensive
then people in the
country would rather prefer to buy domestic goods then the demand for domestic
goods would go
up resulting in expansionary effect such as output, employment investment and
income. This will
work on the assumption only if people switch to domestic goods over foreign goods.
7. If rupee volatility is high then Foreign Portfolio investors will take out
their investment These
investors have invested in equity and bond markets.
8. Exchange rate fluctuations will make firms difficult to forecast their cost and
revenue and have to
undergo a lot of risk and uncertainty. They have no option but to hedge their risk
which involves
again huge cost.
9.Indian firms avoid hedging considering the cost involved in it. But when they
borrow under ECB
will have a lot of difficulties at the payment of repayment debt if currency
depreciates against the $
There would be undue pressure on RBI’s foreign exchange reserves

IMPACT OF EXCHANGE RATE FLUCTATIONS ON

INDIAN ECONOMY

10. If rupee depreciates against the $ the inflation rate (CPI) will go up as well
since CPI includes
goods, services which are imported
11. If rupee appreciates the exports become expensive and imports become cheaper
resulting
lesser exports of goods and services in comparison with more imports of goods and
services
resulting in current account deficit. The current deficit will reflect that the
country is not in a
position to pay for its import bill
12 . Depreciation of currency may help India to contain the import of gold which
helps to control
to Trade balance ( balance of trade) and current account
13. Depreciation of currency may help the economy to control trade deficit/ current
account deficit
with exports cheaper and imports costly
14. An appreciation of currency would help to control imported inflation
especially items like oil
and gold making them cheaper
15.If rupee depreciating then RBI will have to use its precious foreign exchange
reserves to protect
the rupee against the $ by selling $
True or False questions
1. All flexible exchange rate regime countries follow dirty float
2. If rupee depreciates RBI purchases the $
3. Real exchange is low it means foreign goods are expensive
4. Purchasing power parity determines the exchange rate
5. Repo rate is linked to exchange rate

Essay Questions
1. Discuss the different times of exchange rate regimes
2. How is exchange rate is determined under floating exchange rate
system? How changes in exchange affect the home country?
3. What are the various determinants of exchange rate system?
4. Differentiate between nominal and real exchange rate system. How
do you determine the strength of a currency?
5. Write a note on forex market.
6. Discuss the advantages of fixed and flexible exchange rate systems

THANK YOU