FOREIGN EXCHANGE

There is a constant inflow and outflow of goods and services from one country to another. When goods and
services are exported, the money is to be received from the foreigners, and when they are imported, the money
is to be paid to them. The receiving or making of payments to a person, firm or government in foreign countries
involves the transfer of the means of payment across national boundaries and the conversion of the currency of
one country into that of the other country.

MEANING OF FOREIGN EXCHANGE

Foreign exchange plays an important role in the payments of international trade. As we know, the national
currency of a country is not acceptable in making the settlement of international debt, the international
payments, are, therefore, made in the currency of creditor's country only. The manner or the mechanism by
which the foreign debt in foreign currency in exchange of the national currency is settled is referred to as
Foreign exchange.

The term 'foreign exchange' is used in the narrow as well as in the broad sense. In the narrow sense, foreign
exchange simply means the money of a foreign country. For example, Japanese 'Yen' is a foreign exchange to a
Pakistani and Pak rupee is a foreign exchange to a Japanese.

In the broader sense, the word 'foreign exchange' is related to the exchange methods and mechanism through
which the payments in connection with international trade are made. It covers the methods by which (1) the
currency of one country is exchanged for that of another; (2) the forms in which exchanges are conducted and
(3) the ratio at which they are effected.

In the word of H.E. Evitt, "The means and methods by which rights to wealth expressed in terms of the currency
of one country are converted into rights to wealth in terms of the currency of another country are known as
foreign exchange". Hartley Whither defines foreign exchange "as a mechanism by which international
indebtedness is settled between one country and another.

IMPORTANCE OF FOREIGN EXCHANGE

1) Strength of the economy. The financial reserves indicate the financial strength and the stage of development
of the economy. If a nation possesses large reserves of foreign exchange, it indicates the stability, soundness
and the development of the economy.

2) Balance of payments. If a country is facing shortage of foreign exchange and is having persistent adverse
balance of payment, it indicates that the economy is in bad shape.

3) Makes international trade easy. The international payments are made in the currency of creditor's country
on the mutually acceptable rates. This makes the international trade easy.

4) Rate of exchange. The rate of exchange at which the different monetary units are exchanged shows a direct
relationship between the prices of the commodities in the national and international market.

5) Hard currency nation. The foreign exchange balances of a country directly affect the rates of exchange. A
country having large foreign exchange is a sound nation for the other country. A hard currency nation has
stability in foreign exchange rate.

6) Credit worthiness. The rising foreign exchange balances of a nation increases its credit worthiness in the
international capital market.

FOREIGN EXCHANGE MARKET AND ITS FUNCTIONS

A foreign exchange market is a place in which foreign exchange transactions take place. In the words of
Kindleberger, "Foreign exchange market is a place where foreign moneys are bought and sold. It is part of
money market in the financial centres.”
Functions of the Foreign Exchange Market.

There are three main functions of the foreign exchange market. (1) Transfer function (2) Credit function and
(3) Hedging function.

i) Transfer function. The basic function of foreign exchange market is to transfer foreign money between
countries. The main credit instruments used for payments in foreign currencies are letter of credit, bill of
exchange. Banker's draft, Telegraphic transfer.

ii) Credit function. Another function of the foreign exchange market is to provide credit to the importer who is a
debtor. The credit facility is provided through the bill of exchange.

iii) Hedging function. Hedging is the forward rate contract. Foreign exchange market provides the facility to the
importer to pay for the goods at the foreign exchange rate prevailing in the market called Spot Rate or at the
future date called Forward Rate called hedging. Forward exchange rate protects the importer from all risks of
fluctuations in the foreign exchange market.

THE PURCHASING POWER PARITY THEORY (PPP)

According to this theory under inconvertible paper standard, the external value of a currency depends on the
domestic purchasing power of that currency relative to that of another currency. In other words, the rate of
exchange between two inconvertible paper currencies is determined by the equality of their purchasing power
or by their relative price levels. The theory explains that so long there is free trade among nations and exchange
rates are allowed to adjust freely, exchange rate between two currencies will adjust in the long run to the
purchasing power of the two currencies. In the words of Kurihare, "The theory seeks to explain tends time stem
of autonomous paper standard, the external value of a currency depends ultimately and essentially on the
donndard the este power of that currency relative to that of another currency. The theory is presented in wo
versions (1) Absolute Version and (ii) Relative Version.

(i) Absolute Version.

According to the absolute version of the purchasing power parity theory, the rate of exchange between two
countries which are on inconvertible standard is determined at the point at which there is equality between the
purchasing powers of the two currencies. In other words, the rate of exchange would be equal to the ratio of the
outlay required to purchase a particular set of goods. For example, a given basket of internationally traded
goods at a particular period of time is sold for Rs. 600 /= in Pakistan. The same basket of goods is traded in
America for 10 dollars. If cost of transport and other transaction costs are not taken into account, then the
exchange rate between the two countries will be; $ 1 = Rs. 60. The purchasing power of Rs. 60 in Pakistan is
equal to one dollar in America. The idea can be conveyed in the following equation. P ^ 1 =A vee D^ d Here P ^ 1
and P ^ d are indices of foreign and domestic price levels and e is the exchange rate expressed in units.

(ii) Relative version.

Relative version deals with the relationship between changes in internal purchasing power and the changes in
exchange rate between the two countries. According to this theory, the rate of exchange will change in
accordance with the changes in the ratio of price indices of the respective countries. Here some past exchange
rate is assumed to be an equilibrium rate and is adopted as the base rate. The new equilibrium rate can be
worked out by relating the variations in the price levels in the two countries to the base rate. Let us suppose, in
the base year, the exchange rate was Rs. 60 =\$1 of America. The price index in Pakistan has doubled from 100
to 200. We assume further that there is no inflation in America and its price index remains at 100. The new
dollar exchange rate in terms of Pak rupee will be as under: \$ 0.1 = Rs * 0.6 * (200/100)/(100/100) = Rs * 0.12
. 1 = Rs * 0.12

The prices of the same basket of goods in the two countries would be Rs. 120 in Pakistan and dollar one in
America. The exchange rate is=\$ 1 = Rs * 0.12 between the two countries.
The equilibrium rate of exchange calculated in this way represents new parity between the two currencies.

Practically the relative version of the purchasing power theory is more important than its absolute version.

Criticism.

The main criticism levied at the purchasing power parity theory is discussed below.

1. Rate of change is not determined by the relative price levels alone. The purchasing power theory envisages
direct relationship between the purchasing powers of the currency units and the rate of exchange. The fact is
that the rate of change is influenced by many other factors such as tariff's, speculation, capital movements. The
Theory does not take into consideration these other factors.

2. Theory bases analysis on domestic price only. It does not consider the prices of the commodities in the
international market.

3. Theory confines to the internationally traded goods. The peory confilis made up Theory confines to the
internationally traded goods. As the theory confines itself to internationally traded goods, the theory does not
hold good in practice.

4. Effect of changes in foreign exchange rate ignored. The theory asserts that changes in price level induce
changes in the foreign exchange rate. The fact, banges, is that changes in the foreign exchange rates also
influence price levels in many cases. The theory does not take this fact into consideration.

5. The theory ignores the capital account. The theory takes into consideration the merchandize trade accounts
in the balance of payments. It ignores many items like shipping, insurances, banking transactions, income on
investments, long term capital movements, etc., which also influence the exchange rate.

6. Valid only under free trade conditions. The purchasing power parity theory is valid only under free trade
conditions. The free trade conditions do not exist in any country of the world now. The governments have
controlled prices, controlled exchange rates, etc. The rate of exchange prevailing in the country differs
considerably from the actual purchasing power parity.

7. It fails to consider the elasticities of reciprocal demand. According to J.M. Keynes, the Theory fails to consider
the elasticities or reciprocal demand between the two trading countries. As such it is defective.

8. It neglects the influence of aggregate income and expenditure. According to Ragnor Nurkse, the aggregate
income and expenditure have an influence on the volume and value of foreign trade. The theory does not take
this fact into consideration.

Conclusion: Haberler, inspite of all these criticism, regards the purchasing power parity theory useful. It helps
in providing the range within which the equilibrium rate should be located.