NOTES

Specialization Group: International Business (IB)

INTERNATIONAL BUSINESS MANAGEMENT

Code: KMBN IB 01
Unit 4 (6 hours)
Foreign Exchange Determination Systems: Basic Concepts Relating to Foreign Exchange,
Various types of Exchange Rate Regimes, Factors Affecting Exchange Rates, Brief
History of Indian Rupee
Foreign Exchange Rate: Meaning and Its Determination
Meaning:
If a Kashmiri shawlmaker sells his goods to a buyer in Kanyakumari, he will receive in
terms of Indian rupee. This suggests that the domestic trade is conducted in terms of
domestic currency.Within the country, transactions are, then, simple and straight-forward.
But if the Indian shawlmaker decides to go abroad, he must exchange Indian rupee into Jap
yen or dollar or pound or euro. To facilitate this exchange form, banking institutions
appear. Indian shawlmaker will then go to a bank for foreign currencies.
The bank will then quote the day’s exchange rate—the rate at which Indian rupee will be
exchanged for foreign currencies. Thus, foreign currencies are needed for the conduct of
international trade. In a foreign exchange market comprising commercial banks, foreign
exchange brokers and authorised dealers and the monetary authority (i.e., the RBI), one
currency is converted into another currency.
A (foreign) exchange rate is the rate at which one currency is exchanged for another. Thus,
an exchange rate can be regarded as the price of one currency in terms of another. An
exchange rate is a ratio between two monies. If 5 UK pounds or 5 US dollars buy Indian
goods worth Rs. 400 and Rs. 250 then pound-rupee or dollar-rupee exchange rate becomes
Rs. 80 = £1 or Rs. 50 = $1, respectively. Exchange rate is usually quoted in terms of rupees
per unit of foreign currencies. Thus, an exchange rate indicates external purchasing power
of money.
A fall in the external purchasing power or external value of rupee (i.e., a fall in the
exchange rate, say for Rs. 80 = £1 to Rs. 90 = £1) amounts to depreciation of the Indian

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rupee. Consequently, an appreciation of the Indian rupee occurs when there occurs an
increase in the exchange rate from the existing level to Rs. 78 = £1. In other words, the
external value of rupee rises. This indicates strengthening of the Indian rupee. Conversely,
the weakening of the Indian rupee occurs if external value of rupee in terms of pound falls.
Remember that each currency has a rate of exchange with every other currency. Not ail
exchange rates between about 150 currencies are quoted since no significant foreign
exchange market exists for all currencies. That is why exchange rate of these national
currencies are quoted usually in terms of the US dollars and euros.
Determination of Exchange Rate:
Now two pertinent questions that usually arise in the foreign exchange market are to be
answered now. First, how is the equilibrium exchange rate determined, and secondly, why
does exchange rate move up and down?
There are two methods of foreign exchange rate determination. One method falls under the
classical gold standard mechanism and another method falls under the classical paper
currency system. Today, gold standard mechanism does not operate since no standard
monetary unit is now exchanged for gold. All countries now have paper currencies not
convertible to gold.
Under inconvertible paper currency system, there are two methods of exchange rate
determination. The first is known as the purchasing power parity theory and the second is
known as the demand-supply theory or the balance of payments theory. Since today there
is no believer of purchasing power parity theory, we consider only demand-supply
approach to foreign exchange rate determination.
Demand-Supply Approach of Foreign Exchange:
Or, BOP Theory of Foreign Exchange Rate Determination:
Since the foreign exchange rate is a price, economists apply supply-demand conditions of
price theory in the foreign exchange market. A simple explanation is that the rate of
foreign exchange equals its supply. For simplicity, we assume that there are two countries:
India and the USA. Let the domestic currency be rupee.
The US dollar stands for foreign exchange and the value of rupee in terms of dollars (or
conversely, the value of dollars in terms of rupee) stands for foreign exchange rate. Now

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the value of one currency in terms of another currency depends upon the demand for and
the supply of foreign exchange.
Demand for Foreign Exchange:
When Indian people and business firms want to make payments to the US nationals for
using US goods and services or to make gifts to the US citizens or to buy assets there, the
demand for foreign exchange (here dollar) is generated. In other words, Indians demand or
buy dollars by paying rupee in the foreign exchange market. A country releases its foreign
currency for buying imports. Thus what appears in the debit side of the BOP account are
the sources of demand for foreign exchange. Larger the volume of imports, greater is the
demand for foreign exchange.
The demand curve for foreign exchange is negative sloping. A fall in the price of foreign
exchange or a fall in the price of dollar in terms of rupee (i.e., dollar depreciates) means
that foreign goods are now more cheaper. Thus, an Indian could buy more American goods
at a low price. Consequently, imports from the USA would increase—resulting in an
increase in the demand for foreign exchange, i.e., dollar.
Conversely, if the price of foreign exchange or the price of dollar rises (i.e., dollar
appreciates) foreign goods will now be expensive leading to a fall in import demand and,
hence, fall in the demand for foreign exchange. Since price of foreign exchange and
demand for foreign exchange move in opposite directions, the importing country’s demand
curve for foreign exchange is downward sloping from left to right.
In Fig. 6.6, DD1 is the demand curve for foreign exchange. In this figure, we measure
exchange rate expressed in terms of domestic currency that costs 1 unit of foreign currency
(i.e., dollar per rupee) on the vertical axis. This makes the demand curve for foreign
exchange negative sloping. If the exchange rate is expressed in terms of foreign currency
that could be purchased with a 1 unit of domestic currency (i.e., dollar per rupee), the
demand curve would exhibit positive slope. Here we have chosen the former one.
Supply of Foreign Exchange:
In a similar fashion, we can determine the supply of foreign exchange. Supply of foreign
currency comes from receipts for its exports. If the foreign nationals and firms intend to
purchase Indian goods or buy Indian assets or give grants to the Government of India, the
supply of foreign exchange is generated. In other words, what the Indian exports (both

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goods and invisibles) to the rest of the world is the source of foreign exchange. To be more
specific, all the transactions that appear on the credit side of the BOP account are the
sources of supply of foreign exchange.
A rise in the rupee-per-dollar exchange rate means that Indian goods are cheaper to
foreigners in terms of dollars. This will induce India to export more. Foreigners will also
find that investment is now more profitable. Thus, a high price or exchange rate ensures
larger supply of foreign exchange. Conversely, a low exchange rate causes exchange rate
to fall. Thus, the supply curve of foreign exchange, SS1, is positive sloping.
Now we can bring both the demand and supply curves together to determine foreign
exchange rate. The equilibrium exchange rate is determined at that point where the demand
for foreign exchange equals the supply of foreign exchange. In Fig. 6.6, DD1 and SS,
curves intersect at point E. The foreign exchange rate thus determined is OP.

At this rate, quantities of foreign exchange demanded (OM) equals quantity supplied
(OM). The market is cleared and there is no incentive on the part of the players to change
the rate determined. Note that at the rate OP, (say, Rs. 50 = $1) demand for foreign
exchange is matched by the supply of foreign exchange.
If the current exchange rate OP, (suppose, pc 55 = $ 1) exceeds the equilibrium rate of
exchange (OP), there occurs an excess supply of dollar by the amount ‘ab’. Now the bank
and other institutions dealing with foreign exchange, wishing to make money by
exchanging currency, would lower the exchange rate to reduce excess supply.

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Thus, exchange rate will tend to fall until OP is reached. Similarly, an excess demand for
foreign exchange by the amount ‘cd’ arises if the exchange rate falls below OP, i.e., OP.
Banks would then experience a shortage of dollars to meet the demand. The rate of foreign
exchange will rise till demand equals supply.
The exchange rate that we have determined is called a floating or ‘flexible exchange’ rate.
(Under this exchange rate system, the government does not intervene in the foreign
exchange market.) A floating exchange rate, by definition, results in an equilibrium rate of
exchange that will move up and down according to a change in demand and supply forces.
The process by which currencies float up and down following a change in demand or a
change in supply forces is thus illustrated in Fig. 6.7.
6 Factors That Influence Exchange Rates
Aside from factors such as interest rates and inflation, the currency exchange rate is one of
the most important determinants of a country's relative level of economic health. Exchange
rates play a vital role in a country's level of trade, which is critical to most every free
market economy in the world. For this reason, exchange rates are among the most watched,
analyzed and governmentally manipulated economic measures. But exchange rates matter
on a smaller scale as well: they impact the real return of an investor's portfolio. Here, we
look at some of the major forces behind exchange rate movements.
Main Factors that Influence Exchange Rates
Overview of Exchange Rates
Before we look at these forces, we should sketch out how exchange rate movements affect
a nation's trading relationships with other nations. A higher-valued currency makes a
country's imports less expensive and its exports more expensive in foreign markets. A
lower-valued currency makes a country's imports more expensive and its exports less
expensive in foreign markets. A higher exchange rate can be expected to worsen a
country's balance of trade, while a lower exchange rate can be expected to improve it.
eterminants of Exchange Rates
Numerous factors determine exchange rates. Many of these factors are related to the
trading relationship between the two countries. Remember, exchange rates are relative, and
are expressed as a comparison of the currencies of two countries. The following are some
of the principal determinants of the exchange rate between two countries. Note that these

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factors are in no particular order; like many aspects of economics, the relative importance
of these factors is subject to much debate.
Differentials in Inflation
Typically, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of
the 20th century, the countries with low inflation included Japan, Germany, and
Switzerland, while the U.S. and Canada achieved low inflation only later.1 Those countries
with higher inflation typically see depreciation in their currency about the currencies of
their trading partners. This is also usually accompanied by higher interest rates.
Differentials in Interest Rates
Interest rates, inflation, and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries. Therefore, higher interest
rates attract foreign capital and cause the exchange rate to rise. The impact of higher
interest rates is mitigated, however, if inflation in the country is much higher than in
others, or if additional factors serve to drive the currency down. The opposite relationship
exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange
rates.
Current Account Deficits
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest, and dividends. A
deficit in the current account shows the country is spending more on foreign trade than it is
earning, and that it is borrowing capital from foreign sources to make up the deficit. In
other words, the country requires more foreign currency than it receives through sales of
exports, and it supplies more of its own currency than foreigners demand for its products.
The excess demand for foreign currency lowers the country's exchange rate until domestic
goods and services are cheap enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.

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Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with
large public deficits and debts are less attractive to foreign investors. The reason? A large
debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately
paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but
increasing the money supply inevitably causes inflation. Moreover, if a government is not
able to service its deficit through domestic means (selling domestic bonds, increasing the
money supply), then it must increase the supply of securities for sale to foreigners, thereby
lowering their prices. Finally, a large debt may prove worrisome to foreigners if they
believe the country risks defaulting on its obligations. Foreigners will be less willing to
own securities denominated in that currency if the risk of default is great. For this reason,
the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is
a crucial determinant of its exchange rate.
Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a greater
rate than that of its imports, its terms of trade have favorably improved. Increasing terms of
trade shows' greater demand for the country's exports. This, in turn, results in rising
revenues from exports, which provides increased demand for the country's currency (and
an increase in the currency's value). If the price of exports rises by a smaller rate than that
of its imports, the currency's value will decrease in relation to its trading partners.
Strong Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment
funds away from other countries perceived to have more political and economic risk.
Political turmoil, for example, can cause a loss of confidence in a currency and a
movement of capital to the currencies of more stable countries.

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The Bottom Line
The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases the
purchasing power of income and capital gains derived from any returns. Moreover, the
exchange rate influences other income factors such as interest rates, inflation and even
capital gains from domestic securities. While exchange rates are determined by numerous
complex factors that often leave even the most experienced economists flummoxed,
investors should still have some understanding of how currency values and exchange rates
play an important role in the rate of return on their investments.