EXCHANGE RATE DETERMINATION

Structure
11.0 Objectives
11.1 Introduction
11.2 Exchange Rate Regimes
11.2.1 Floating Exchange Rate
11.2.2 Fixed Exchange Rate
11.2.3 Managed Floating

11.3 Nominal vs. Real Exchange Rates

11.3.1 Nominal Exchange Rates
11.3.2 Change in Exchange Rate
11.3.3 From Nominal to Real Exchange Rates

11.4 Interest Rate Parity Equation

11.5 Asset Market Approach to Exchange Rate Determination
11.5.1 Expected Rate of Return to Assets
11.5.2 Foreign Exchange Market Equilibrium: Asset Market Approach

11.6 Purchasing Power Parity (PPP)

11.7 Monetary Approach to Exchange Rate Determination
11.8 Let Us Sum Up
11.9 Answers/ Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After going through this unit you will be in a position to
• explain the concepts of nominal and real exchange rates;
• distinguish between various types of exchange rate regimes;
• compare returns to assets denominated in different currencies;
• apply the interest parity condition to find the equilibrium exchange rate;
• explain the Purchasing Power Parity (PPP) theory of exchange rate; and
• explain the monetary approach to exchange rate determination.

11.1 INTRODUCTION
One of the key economic decisions a country takes is how it will value its
currency in comparison to other currencies. An exchange rate regime is how a
country manages its currency in the foreign exchange market. An exchange rate
regime is closely related to the country's monetary policy.
 Balance of
Payments and
A country can manage its currency in a foreign exchange market under three
Exchange Rate types of exchange rate regimes, viz., (i) floating exchange rate, (ii) fixed
exchange rate, and (iii) managed floating exchange rate. A floating exchange
rate regime is where the central bank determines the money supply and let the
exchange rate adjust freely according to market forces. In many countries,
however, the central bank acts under implicit or explicit exchange rate target
and uses monetary policy to achieve those targets. This type of exchange rate
arrangement is called fixed exchange rate regime. There is another type, i.e.,
managed floating, where the central bank influences the exchange rate without
having a specific exchange rate path or target. Central to the decision of
whether to buy domestic goods or foreign goods is the price of domestic goods
relative to foreign goods, that is, the exchange rate.
In this Unit we will discuss how the exchange rate is determined, and the role
of exchange rate in international trade. First we learn how exchange rate allows
us to compare the prices of goods produced by different countries.
Subsequently we describe the international asset market in which currencies are
traded. This is followed by a section on asset approach by showing how today’s
exchange rate responds to changes in the expected future values of exchange
rates. The asset approach explains the exchange rate determination in the short
run. To understand long term exchange rate movements, we discuss the
monetary approach to exchange rate determination. In the long run, the price
level plays a key role in determining both interest rate and exchange rate.

11.2 EXCHANGE RATE REGIMES

As mentioned above, there are three basic types of exchange regimes: floating,
fixed, and managed floating. We discuss each of the above types below.
11.2.1 Floating Exchange Rate
A floating exchange rate is a type of exchange rate regime wherein a currency's
value is allowed to fluctuate according to the foreign exchange market. A
currency that uses a floating exchange rate is known as a floating currency. The
dollar is an example of a floating currency.
Many economists believe that floating exchange rate is the best possible
exchange rate regime because it automatically adjusts to economic
circumstances. It enables a country to dampen the impact of shocks and
foreign business cycles. Further, it pre-empts the possibility of having a balance
of payments crisis. However, they also engender unpredictability as the result of
their dynamism.
11.2.2 Fixed Exchange Rate
A fixed exchange rate system, or pegged exchange rate system, is a currency
system in which governments try to maintain a currency value that is constant

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against a specific currency or good. In a fixed exchange-rate system, a country's now.
government decides the worth of its currency in terms of either a fixed weight
of an asset, another currency, or a basket of other currencies. The central bank
of a country remains committed at all times to buy and sell its currency at a
fixed price.
In these countries, the central bank does not let the exchange rate adjust freely
in whatever manner as implied by equilibrium in the foreign exchange market.
Central banks act under implicit or explicit exchange rate targets and use
monetary policy to achieve those targets. The targets are sometimes implicit,
sometimes explicit; they are sometimes specific values, sometimes bands or
ranges. These exchange rate arrangements (or regimes, as they are called) have
many names. China at present has a fixed exchange rate.

Pegs, Crawling Pegs, Bands

At one end of the spectrum are countries with flexible exchange rates, such as
the USA or Japan. These countries do not have explicit exchange rate targets.
At the other end are countries that operate under fixed exchange rates. These
countries maintain a fixed exchange rate in terms of some foreign currency.
Some peg their currency to the dollar. Still other countries peg their currency to
a basket of foreign currencies, with the weights reflecting the composition of
their trade.
To ensure that a currency will maintain its ‘pegged’ value, the country’s central
bank maintains reserves of foreign currencies and gold. They can sell these
reserves in order to intervene in the foreign exchange market to make up
excess demand or take up excess supply of the country's currency.
Between these extremes are countries with various degrees of commitment to
an exchange rate target. For example, some countries operate under a crawling
peg. The name describes it well: these countries typically have inflation rates
that exceed the US inflation rate. If they were to peg their nominal exchange
rate against the dollar, the more rapid increase in their domestic price level
above the US price level would lead to a steady real appreciation and rapidly
make their goods uncompetitive. To avoid this effect, these countries choose a
predetermined rate of depreciation against the dollar. They choose to ‘crawl’
(move slowly) vis-à-vis the dollar.
11.2.3 Managed Float
Under this exchange rate regime, the central bank attempts to influence the
exchange rate without having a specific exchange rate path or target. Indicators
for managing the exchange rate are broadly judgmental (e.g., balance of
payments position, foreign exchange reserves, parallel market developments),
and adjustments may not be automatic. Intervention may be direct or indirect.
The Reserve Bank of India follows a managed floating exchange rate as of
129
 Exchange Rate Determination

130
Balance of
Payments and 11.3 NOMINAL VS. REAL EXCHANGE RATES
Exchange Rate
Central to the decision of whether to buy domestic goods or foreign goods is
the price of domestic goods relative to foreign goods. We call this relative price
the real exchange rate. The real exchange rate is not directly observable, and
you will not find it in newspapers. What you will find in newspapers are
nominal exchange rates, the relative prices of currencies.
11.3.1 Nominal Exchange Rate
Nominal exchange rate between two currencies can be quoted in one of
the following two ways:
• It is the price of the domestic currency in terms of the foreign currency. If,
for example, we look at the US and the Euro area and think of the dollar as
the domestic currency and the Euro as the foreign currency, we can express
the nominal exchange rate as the price of a dollar in terms of Euros. For
instance, an exchange rate of 0.86 means $1 is worth €0.86.
• As the price of the foreign currency in terms of the domestic currency –
continuing with the same example, we can express the nominal exchange
rate as the price of a Euro in terms of dollars. For instance, the exchange
rate defined this way is 1.15 which implies that €1 is worth $1.15.
Either definition is fine; we define the nominal exchange rate as the price of the
domestic currency in terms of foreign currency and denote it by E. When
looking, for example, at the exchange rate between the US and the Euro area
(from the viewpoint of the US, so the dollar is the domestic currency), E
denotes the price of a dollar in terms of Euros (so, for example, E was €0.86/$).
11.3.2 Change in Exchange Rate
Exchange rates between most foreign currencies change every day and every
minute of the day. These changes are called nominal appreciations or nominal
depreciations – appreciations or depreciations for short:
An appreciation of the domestic currency is an increase in the price of the
domestic currency in terms of a foreign currency. In other words, a unit of
domestic currency can buy more units of foreign currency. Given our definition
of the exchange rate, an appreciation corresponds to an increase in the
exchange rate. When the dollar becomes more valuable relative to other
currencies, we say that the dollar has appreciated.
A depreciation of the domestic currency is a decrease in the price of the
domestic currency in terms of a foreign currency. . In other words, a unit of its
currency can buy fewer units of foreign currency. So, given our definition of
the exchange rate, a depreciation of the domestic currency corresponds to a
decrease in the exchange rate, E. In our example, we say that the dollar has
depreciated when it becomes less valuable relative to other currencies.

131
 Although the terms appreciation and depreciation are used to describe Exchange Rate
movements of exchange rates in free markets, a different set of terms is Determination
employed to describe increases and decreases in currency values that are set by
government decree. These are called devaluation and revaluation. These two
terms are used when countries operate under fixed exchange rates. The label
‘fixed’ is a bit misleading: it is not the case that the exchange rate in countries
with fixed exchange rates never actually changes. But changes are rare.
Because these changes are rare, economists use specific words to distinguish
them from the daily changes that occur under flexible exchange rates. A
decrease in the exchange rate under a regime of fixed exchange rates is called
devaluation rather than depreciation, and an increase in the exchange rate under
a regime of fixed exchange rates is called a revaluation rather than an
appreciation. In other words, when an officially set exchange rate is altered so
that a unit of a country’s currency buys fewer units of foreign currency, we say
that the devaluation of that currency has occurred. When the exchange rate is
altered so that the currency buys more units of foreign currency, we say that an
upward revaluation has taken place.
11.3.3 From Nominal to Real Exchange Rate
How do we construct the real exchange rate between the Dollar and the Euro?
The US and the Euro area produce many goods, and we want to construct a real
exchange rate that reflects the relative price of all the goods produced in the US
in terms of all the goods produced in the Euro area. We must use a price index
for all goods produced in the US and a price index for all goods produced in the
Euro area.
Let P be the GDP deflator for the US, P* be the GDP deflator for the Euro area
(as a rule, we shall denote foreign variables with an asterisk) and E be the
dollar– euro nominal exchange rate. Two steps are involved in calculating real
exchange rate from nominal exchange rate.
a) The price of US goods in dollars is P. Multiplying it by the exchange rate, E
– the price of dollars in terms of Euros – gives us the price of US goods in
Euros, EP.
b) The price of Euro area’s goods in Euro is P*. The real exchange rate (in
symbols, say, R), the price of US goods in terms of Euro area’s goods, is
thus given by
R = EP/P* ... (11.1)
The real exchange rate is constructed by multiplying the domestic price level by
the nominal exchange rate and then dividing by the foreign price level. Similar
to nominal exchange rates, the real exchange rates move over time. These
changes are called real appreciations or real depreciations.
An increase in the real exchange rate – that is, an increase in the relative price
of domestic goods in terms of foreign goods – is called a real appreciation.
A

132
Balance of
decrease in the real exchange rate – that is, a decrease in the relative price of
Payments and
Exchange Rate domestic goods in terms of foreign goods – is called a real depreciation.

11.4 INTEREST PARITY EQUATION

Openness in financial markets implies that people (or financial institutions, for
example, investment trusts, that act on their behalf) face a new financial
decision: whether to hold domestic assets or foreign assets. They have to make
a choice between the holdings of domestic interest-paying assets versus foreign
interest- paying assets. Let us think of these assets for now as domestic one-
year bonds and foreign one-year bonds. Consider, for example, the choice
between US one- year bonds and Euro one-year bonds, from your point of
view, as a US investor: Suppose you decide to hold US bonds.
Let rt be the one-year US nominal interest rate in year t (the subscript t refers to
the year). Then, for every $1 you put in US bonds, you will get $(1×rt) next
year.
Suppose you decide instead to hold Euro bonds. To buy Euro bonds, you first
buy Euros at nominal exchange rate. Let Et be the nominal exchange rate

t 𝑟 denote the one-year nominal interest rate on Euro bonds (in Euros) in
between the Euro and the Dollar at the start of year t. For every $1, you get €
∗
Et. Let
year
t. When the next year comes, you will have € E t (1 ×𝑟t∗). You will then have to

next year to be 𝐸t+

convert your Euros back into dollars. If you expect the nominal exchange rate
e
(the superscript ‘e’ indicates that it is an expectation; you do
1
not yet know what the euro/dollar exchange rate will be in year t + 1), each

will be worth $ 1 . So you can expect to have $ (1 + 𝑟∗) (1/ ) next year
euro
𝐸
e
e
Et+ t t 𝐸t+1
1

for every $1 you invest

now.
Thus, two factors are important while deciding on the bonds you should hold,
viz., (i) the relative interest rates in the US and the Euro area; and (ii) the
expected nominal exchange rate between Dollar and Euro. You should note
that, it is expected exchange rate – therefore, involves certain uncertainty. If
investment in a currency is found to be risky (because of country specific
incidents such as war, recession, political instability, etc.), there is sudden and
widespread outflows of capital from that country. Such conditions lead to
unexpected and substantial depreciation of that currency.
Let us now assume that financial investors care only about the expected rate of
returns and therefore want to hold only the asset with the highest expected rate
of returns. In that case, if both US bonds and Euro bonds are to be held, they
must have the same expected rate of returns. In other words, the following
relationship must hold:
133
 (𝟏
𝟏 + 𝐫𝐭) = 𝑬𝒕 (𝟏 + 𝒓 ) )
∗

( / 𝒆
𝑬𝒕+𝟏
... (11.2)
𝒕

Reorganising the above, we have

134
(𝟏∗)+ 𝐫 ) = (𝟏 +
𝒓 𝑬
( / 𝒆)
Exchange Rate
𝒕
𝐭
Determination
𝒕
... (11.3)
�𝒕+𝟏
�
Equation (11.3) is called the ‘uncovered interest parity relation’. The
assumption that financial investors will hold only the bonds with the highest
expected rate of returns is obviously too strong, for two reasons:
1) It ignores transaction costs. Going into and out of US bonds requires three
separate transactions, each with a transaction cost.
2) It ignores risk. The exchange rate a year from now is uncertain; holding US
bonds is therefore more risky, in terms of Euros, than holding Euro bonds.
The adjective ‘uncovered’ is added to distinguish this relation from another
relation called the ‘covered interest parity condition’. The covered interest
parity condition is derived by looking at the following choice: Buy and hold
Euro bonds for one year. Or buy dollars today, buy one-year US bonds with the
proceeds and agree to sell the dollars for Euros a year ahead at a predetermined
price (called the forward exchange rate). The rate of returns to these two
alternatives, which can both be realised at no risk today, must be the same. The
covered interest parity condition is a riskless arbitrage condition.
Interest Rate and Exchange Rate

𝐸 )⁄ ]
Let us get a better sense of what the interest parity condition implies. First, let us
t
/ e 𝟏/ (
𝒆
[
rewrite as
𝐸 𝑬𝒕+𝟏 −
t+1 𝟏 𝑬𝒕
+ 𝑬𝒕

𝐸
t
/ e
� t+1 with above expression in equation (11.2) gives
Replacing

�
(𝟏+𝒓∗)
𝟏+𝒓 =
( 𝒕) [𝟏+(𝑬𝒕+
𝒆 𝒕
... (11.4)
–𝑬𝒕)⁄𝑬𝒕]

𝑟t and foreign nominal interest rate, 𝑟

Equation (11.4) indicates the relationship between domestic nominal interest rate,
∗
t , and expected rate of appreciation of the
domestic currency,
(𝐸t+e − 𝐸t)⁄𝐸t
1
A good approximation to the above is given by

∗ 𝑬𝒆 − 𝑬𝒕
𝒓𝒕 ≈ 𝒓𝒕 − 𝒕+𝟏
/𝑬 )
( 𝒕
... (11.5)

135
 Equation (11.5) is called the interest parity condition. The left-hand side of
equation (11.5) is the rate of return on dollar assets and the right-hand side is
the expected rate of return on euro assets when expressed in dollars. The
interest

136
Balance of
parity condition thus holds when the expected returns on deposits of any two
Payments and
Exchange Rate currencies, measured in the same currency are equal. This is the form of the
interest parity condition you must remember: arbitrage by investors implies
that the domestic interest rate must be equal to the foreign interest rate minus
the expected appreciation rate of the domestic currency. Note that the expected
appreciation rate of the domestic currency is also the expected depreciation rate
of the foreign currency. Thus, equation (11.5) is equivalent to the following: the
domestic interest rate must be equal to the foreign interest rate minus the
expected depreciation rate of the foreign currency.
Check Your Progress 1
1) What are the different kinds of exchange rate regimes? State the difference
among them.
.......................................................................................................................
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.......................................................................................................................
.......................................................................................................................

2) What is meant by interest parity condition?

.......................................................................................................................
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11.5 ASSET MARKET APPROACH TO EXCHANGE

RATE DETERMINATION
Market determined exchange rates exhibit considerable volatility. A variety of
studies shows that the volatility of short-run exchange rate returns is
indistinguishable from stock or bond market volatility. Because of this
similarity, most economists rely on asset market models to explain short-run
exchange rate behaviour. The chief characteristic of an asset market model is its
emphasis on forward-looking behaviour. Asset prices today are determined in
large part on expectations of the future performance of an asset. If people think
an asset will rise in value in the future, they will be willing to pay more for that
asset today, and its price will tend to rise. The same logic holds for foreign
currencies.
11.5.1 Expected Rate of Return to Assets
Suppose today’s euro/dollar rate is €1.00 per dollar and the exchange rate you

appreciation against the euro is (1.05 − 1.00)⁄1.00 = 0.05 or 5 percent

expect after one year is €1.05 per dollar. Then the expected rate of dollar

per
137
 year. It means that a euro deposit must give 5% extra returns than a dollar deposit

138
to compensate for the loss in value on converting euro into dollar after a year Exchange Rate
because of dollar appreciation. Determination

Now suppose that today’s exchange rate suddenly jumps up to €1.03 per dollar
(an appreciation of dollar and a depreciation of euro) but the expected future

(1.05 − 1.03)⁄1.03 = 0.019 or 1.9 percent instead of 5 percent. Since 𝑟E

rate is still €1.05 per euro. The expected rate of appreciation is now only

changed, the dollar return on euro deposits, which is the difference between 𝑟E
has not

and the expected rate of appreciation, has risen by 3.1 percentage points per
year (5 percent – 1.9 percent).
An appreciation of dollar against the euro makes euro deposits more attractive
relative to dollar deposits (by increasing the expected dollar returns on euro
deposits). To arrive at this result, we have assumed that the expected future
euro/dollar rate and interest rates do not change. A dollar appreciation today,
for example, means the dollar now needs to appreciate by a smaller amount to
reach any given expected future level.
Fig. 11.1 shows that for fixed values of the expected future euro/dollar
exchange rate and the euro interest rate, the relation between today’s
euro/dollar exchange rate and the expected dollar returns on euro deposits is an
upward sloping schedule.

RR
Exchange
Rate E€/$

Expected Rate of Return (in dollars)

Fig. 11.1: Expected Rate of Return of Euro Assets in Dollars

Fig. 11.1 illustrates the RR schedule as a relation between today’s euro/dollar

exchange rate and the expected dollar return on euro deposits.
139
 Balance of
Payments and
11.5.2 Foreign Exchange Market Equilibrium: Asset Market Approach
Exchange Rate Foreign exchange market will be in equilibrium when interest parity condition
holds. Foreign exchange market is in equilibrium when deposits of all
currencies offer the same expected rate of returns. The condition that the
expected returns on deposits of any two currencies are equal when measured in
the same currency is called the interest parity condition. Let us see why foreign
exchange market is in equilibrium when the interest parity condition holds.
Suppose that the dollar interest rate is 6 percent and euro interest rate is 10
percent but dollar is expected to appreciate at 6 percent over a year. In this
circumstance, the expected rate of returns on euro deposits would be 2 percent
lower than that on dollar deposits. This means that no one will be willing to
continue holding euro deposits and the holders of euro deposits will be trying to
sell them for dollar deposits. There will therefore be an excess supply of Euro
deposits and an excess demand for Dollar deposits in the foreign exchange
market.
When all expected rates of returns are equal (that is, when interest parity
holds), there is no excess supply of certain type of deposit and no excess
demand for another. Thus, the foreign exchange market is in equilibrium when
the following condition is met:
Expected rate of return on Dollar deposits = Expected rate of return on Euro
deposits

𝒓𝑼𝑺 𝑬
𝒆
–
= 𝑬€/$
𝒓𝑬 — ( €/$ )
𝑬€/$
... (11.6)

In Fig. 11.2, the vertical schedule indicates 𝑟US , the return on dollar deposits
measured in terms of dollars. The upward sloping schedule, RR shows how the
expected return on euro deposits, measured in terms of dollars depends on the

indicated by the intersection of the two schedules at point 1, €/𝐸1

current euro/ dollar exchange rate. The equilibrium euro/dollar rate is the one
. At
this $

e
E – E€/$
exchange rate, the returns on dollar and euro deposits are equal, so that the
= — ( €/$
), is satisfied.
𝑟US
E€/$
𝑟E
interest parity condition,

In Fig. 11.2, the vertical schedule indicates the returns to dollar deposits
measured in dollars and the RR schedule which represent the relation between
the expected return on euro deposits measured in dollars and the current
exchange rate. Equilibrium occurs at point 1, where two schedules intersect.

deposits tells us that at the exchange rate 𝐸

The upward sloping schedule measuring the expected euro return on dollar
3

than the rate of return on dollar deposits, 𝑟US . In this situation anyone
€/ , the rate on euro deposits is less
$

holding
euro deposits wishes to sell them for the more lucrative dollar deposits. The
140
foreign exchange market is out of equilibrium. The unhappy owners of euro

rate, 𝐸3 ,
deposits attempt to sell them for dollar deposits, but because the return on
dollar deposits is higher than that on euro deposits at the exchange
$
€/
no holder
of a dollar deposit is willing to sell it for euro at that rate.

141
 Exchange Rate
Determination
Return on dollar deposits
RR
Exchange
Rate E€/$

2
€/$
�
� 2

1
Expected return on euro
�€/$ deposits
�3 1

�€/$
�
3

rU.S
Fig. 11.2: Equilibrium in the Foreign Exchange Market: Asset Approach
Expected Rate of Return (in

price for dollar, the euro/dollar exchange rate rises towards 𝐸

As euro holders try to entice dollar holders to trade by offering them a better
1

become cheaper in terms of dollars. Once the exchange rate reaches€/ 𝐸1

€/ that is, euors
$
,
euro $

and dollar deposits offer equal returns and holders of euro deposits no longer

reverse if we were initially at point 2 with an exchange rate of 𝐸

have an incentive to try to sell them for dollars. The same process works in
2
. At point
$
€/
2,
the return on euro deposits exceeds that on dollar deposits, so there is now an
excess supply of the latter. As unwilling holders of dollar deposits bid for the
more attractive euro deposits, the price of euro in terms of dollars tends to rise

has moved to 𝐸
that is, the Dollars tend to depreciate against the Euro. When the exchange rate
1
, rates of return are equalized across currencies and the
$
€/
market
is in equilibrium.

11.6 PURCHASING POWER PARITY (PPP)

The short run movements in the exchange rates are governed by asset market
conditions, the long run fluctuations in the exchange rates are anchored by
goods market conditions. The long run pattern is known as purchasing power
parity. The notion of PPP is one of the oldest concepts in economics.
142
Purchasing Power Parity (PPP) theory is based on the ‘Law of One Price’.
Goods denominated in the same currency should have identical price between
markets

143
 Balance of
after adjusting for transportation costs. If a price difference exists between two
Payments and
Exchange Rate markets, then arbitrage is possible. Traders would buy products from the low-
price market and sell it in the high-price market. Consequently, prices would
converge to one price across all markets as traders shift the supply of goods
from the low-price market to the high-price market. The prices in the high-price
market would fall while prices in the low-price market would rise over time.
Price could differ between markets because the price differential reflects the
transportation costs of the product from one market to another. Nevertheless,
the PPP helps predict changes in exchange rates.
The PPP refers to the idea that the same basket of goods should cost the same

So, for instance, suppose P$ is the price of a bundle of goods in the United States
when prices are measured in the same currency regardless of where it is located.

and let P€ equal the price of an identical bundle in Italy (measured in Euros). If
the two bundles are to have the same price, the following relationship must hold:

𝐄€/$
=
... (11.7)
𝐏€
𝐏
$

exchange rate will be E€/$. The PPP theory therefore predicts that a fall in a
The theory of PPP says that the long-run equilibrium value of the actual

currency’s domestic purchasing power (as indicated by an increase in the

domestic price level) will be associated with a proportional currency
depreciation in the foreign exchange market. Symmetrically, PPP predicts that
an increase in the currency’s domestic purchasing power will be associated
with a proportional currency appreciation.
By re-arranging, we get

𝐏$
𝐏€
=
... (11.8)
𝐄€/
$

The left side of equation (11.8) is the dollar price of the reference commodity
basket in the US; the right side is the dollar price of the reference basket when
purchased in Euro area. Thus, PPP asserts that the price levels of all the
countries are equal when measured in terms of the same currency.
Let us take an example to understand this. Suppose the CPI for the US equals
$755.3 while the CPI for Euro area is €1,241.2 Euros. Thus, the absolute PPP

𝐏€
predicts the exchange rate should be 1.64 Euros per dollar.
𝟏𝟐𝟒𝟏. 𝟐 𝟏. 𝟔𝟒
𝐄€/$ = = 𝐄𝐮𝐫𝐨𝐬
𝐏$ = 𝐄𝐮𝐫𝐨𝐬
𝟕𝟓𝟓. 𝟑 𝟏
𝐃𝐨𝐥𝐥𝐚𝐫𝐬

144
If the spot exchange rate is 1.4 Euros per 1 dollar, subsequently, traders use
arbitrage. The CPI in U.S. in Euros is 1057.42 (or $755.3 * 1.4 €/$) which is
smaller than the CPI of the Euro area. Thus, traders could profit by purchasing
a basket of goods from US and selling it in the Euro area. Thus, they potentially
earn €1,241.20 – €1,057.42 = €183.78 per basket of goods.

145
 Absolute PPP and Relative PPP Exchange Rate
Determination
The statement that exchange rates equal relative price levels is sometimes
referred to as the absolute PPP. Absolute PPP implies a proposition known as
the relative PPP, which states that the percentage change in the exchange rate
between two currencies over any time period equals the difference between
percentage changes in national price levels during the same time period.
Relative PPP thus translates absolute PPP from a statement about price and
exchange rate levels into one about price and exchange rate changes. It asserts
that prices and exchange rates change in a way that preserves the ratio of each
currency’s domestic and foreign purchasing power.

Foreign country’s (Euro area in our example) inflation between now and period

T = 𝜋€

Domestic country’s (US in our example) inflation between now and period

T = 𝜋$
𝐸0 and 𝐸T are the domestic exchange rates (defined as euros per
dollar)
€⁄$ €⁄$ P€
measured at time 0 and T. Thus, the exchange rate at time 0 is 𝐸0 =
€⁄$ P$

𝑷€(𝟏+𝝅
The €)
exchange rate at time T is 𝑬 = 𝑻
... (11.9)
€⁄$ 𝑷$(𝟏+𝝅$)

Exchange rate change will then be

𝑻 𝟎 𝑷€(𝟏+𝝅€) 𝑷€
𝑬€⁄$–𝑬€⁄$ –
=
𝑷$(𝟏+𝝅$)
𝑷$ ... (11.10)
𝑬€𝟎⁄ 𝑷€
𝑷
$
𝟏+𝝅€
= − 𝟏
𝟏+𝝅$
... (11.10 a)

We use linear approximation to obtain the following

𝑻 𝟎
𝑬 ⁄ –𝑬 ⁄
≈ 𝝅€ − 𝝅$
€ $ € $
𝑬€𝟎⁄
... (11.10 b)

If the US price level rises by 10 percent over a year and Euro area’s rises by
only 5 percent, for example, relative PPP predicts a 5 percent depreciation of
the dollar against the euro. The dollar’s 5 per cent depreciation against the Euro
just gets cancelled with the 5 per cent extra inflation in the US than the Euro
area, leaving the relative domestic and foreign purchasing powers of both
currencies unchanged.

11.7 MONETARY APPROACH TO EXCHANGE

RATE DETERMINATION
146
The theory of PPP is a statement that exchange rates and domestic and foreign
price levels should move together in the long run. It says nothing about what

147
 Balance of
causes any of these three variables to move. To close the circle, we need to add
Payments and
Exchange Rate elements to the model. This is done with a theory of exchange rate behaviour
known as monetary approach to exchange rate determination. The monetary
approach to exchange rate is the workhorse theory of long-run exchange rate
behaviour. It was developed in the 1970s by economists at University of
Chicago and has been widely studied over the past 40 years.
The monetary approach to exchange rate has two fundamental building blocks.
The first is purchasing power parity. The second is the agents in the two
countries in question have well defined stable demands for real money balances
as a function of national income and interest rates. Imposing money market
equilibrium and PPP, it is straight forward to show that the theory predicts the
following equation for the exchange rate:

𝐄€/$
𝐏€
= 𝐏$

Money Market will be in equilibrium when the demand for money exactly
matches the supply of money. The money is demanded for three motives
namely transaction motive, precautionary motive and speculative motive by
households, firms and governments. The aggregate demand for money in turn is
affected by three factors: (i) The interest rate: A rise in the interest rate causes
each individual in the economy to reduce their demand for money; (ii) The
price level: If the price level rises, agents will have to spend more than before
to purchase the same basket, they will therefore have to hold more money; and
(iii) Real national income: An increase in the real national income raises the

rate, and Y is real GNP, the aggregate demand for money, 𝑀d , can be
demand for money, given the price level. If P is the price level, r is the interest

expressed as
𝑴𝒅 = 𝑷 × (𝒓, 𝒀) ... (11.11)
Thus, aggregate real money demand, (𝑟, 𝑌) , is equal to
𝑴𝒅
= (𝒓, 𝒀)
𝑷
... (11.12)

Money Supply: An economy’s supply of money is controlled by the central bank.

s
We will thus take the real money supply, M , as given.
P

The equilibrium in the money market is given by the equality between

real money demand and real money supply.

𝑴𝒔 𝑴𝒅
𝑷 𝑷
=
... (11.13)

From equation (11.12) we get:

= (𝒓, 𝒀)
𝑴𝒔

𝑷
... (11.14)

By re-arranging equation (11.14), we can explain the domestic price level in

terms of domestic money demand and supply.
148
 𝑴𝑼𝑺
𝒔
𝑷𝑼𝑺 =
𝑳(𝒓$,,𝒀
... (11.15)
$)

149
 In the case of Euro Exchange Rate
area Determination
𝑴
𝒔

𝑷𝑬
𝑬
𝑳(𝒓€,𝒀
=
… (11.16)
𝑬)

The monetary approach makes the general prediction that the exchange rate,
which is the relative price of the US and the Euro area, is determined in the
long run by the relative supplies of those monies and the relative real demands
for them. Shifts in interest rates and output levels affect the exchange rate only
through their influences on money demand.
In addition, the monetary approach makes a number of specific predictions
about the long run effects on the exchange rate of changes in money supplies,
interest rates and output levels.

𝑀US causes a proportional increase in the long run US price level 𝑃US.
a) Money Supply: Other things equal, a permanent rise in US money supply

S
Under PPP, an increase in the U.S. money supply causes a proportional
long run depreciation of the dollar against the euro. Predictions in part
(a)
should seem straightforward. In essence, they say that if a country prints
more of its own money (everything else held constant), it will decrease
in value in foreign exchange markets. This is because a rise in home
(foreign) money will introduce inflationary pressures in home (foreign)
country.
b) Interest Rate: A rise in the interest rate 𝑟$ on dollar denominated assets
lowers real U.S. money demand, (𝑟$, 𝑌US). By equation 11.15, the long
run U.S. price level rises, and under PPP the dollar must depreciate
against the euro in proportion to this U.S. price level increase.

(𝑟$, 𝑌US) , leads to a fall in the long run U.S. price level (equation 11.15).
c) Output Level: A rise in the U.S. output raises real U.S. money demand

According to PPP, there is an appreciation of the dollar against the euro.

Predictions (b) and (c) show how changes in variables that influence money
demand (everything else held constant) also can influence the exchange rate. In
particular, growth in the home (foreign) interest rate lowers money demand and
raises home (foreign) prices. Working through PPP, this depreciates (appreciates)
the exchange rate. Growth in home (foreign) income raises money demand and
puts downward pressure on home (foreign) prices. Working through PPP, this
appreciates (depreciates) the exchange rate.

Check Your Progress 2

1) State the difference between absolute PPP and relative PPP.
.........................................................................................................................
.........................................................................................................................

150
.........................................................................................................................
.........................................................................................................................

151
 Balance of
Payments and
US SUM UP
Exchange Rate
In this unit, we discussed how exchange rate is determined through the
2) xplain
interplay of interest rates, price level, and the demand for and supply of money.
the
Exchange rate, which is the price of domestic goods relative to foreign goods,
general
is central to the decision of export and import and hence, to international trade.
prediction
of the A country’s decision on whether market forces will determine its exchange rate
monetary or government will maintain a constant exchange rate or monetary authority
approach will influence exchange rate, will determine its exchange rate regime- fixed;
to long floating or managed floating.
run
exchange The asset approach to exchange rate determination is based on the premise that
rate asset prices today are determined in large part on expectation of the future
determina performance of an asset. Central to the determination of exchange rate is the
tion. interest parity condition which holds when the expected return on deposits of
..................... any two currencies, measured in the same currency are equal. Foreign
..................... exchange market attains equilibrium when interest parity holds. This is how
..................... equilibrium exchange rate is determined.
.....................
..................... Economists believe that long run exchange rates are determined by the
................ monetary approach to exchange rate determination based on (a) PPP and (b)
..................... stable demands for real money balances as a function of national income and
..................... interest rates. PPP implies that exchange rates are determined by relative price
..................... levels. Imposing money market equilibrium and PPP, the monetary approach
.....................
..................... makes the general prediction that the exchange rate is fully determined in the
................ long run by the relative supplies of those monies and the relative real demands
..................... for them.
.....................
..................... 11.11 ANSWER TO CHECK YOUR
.....................
.....................
PROGRESS EXERCISES
................ Check Your Progress 1
.....................
..................... 1) There are three basic types of exchange rate regimes: floating – wherein a
..................... currency’s value is allowed to fluctuate according to the foreign exchange
.....................
market; fixed – wherein government try to maintain a currency value that is
.....................
................
.....................
.....................
.....................
.....................
.....................
................

11.8 LET
152
 constant against a specific currency or good; managed floating- wherein Exchange Rate
monetary authority attempts to influence the exchange rate without any Determination
specific target.

2) Interest parity condition holds when the expected return to deposits of two
currencies are equal, when measured in the same currency. This implies
that domestic interest rate must equal foreign interest rate minus the
expected appreciation rate of the domestic currency.

Check Your Progress 2

1) Absolute PPP implies that the exchange rates equal relative price levels.
Relative PPP states that the percentage change in the exchange rate between
two currencies over any period equals the difference between percentage
changes in national price levels.
2) It states that the exchange rate is fully determined in the long run by the
relative supplies of those monies and the relative real demands for them.
Shifts in interest rates and output levels affect the exchange rate only through
their influences on money demand.

153
 GLOSSARY
Absolute PPP : It implies that exchange rate equals relative price levels.

Accommodating : Accommodating capital movements are capital flows that

Capital Flows take place specifically to equalise the balance of payments
in the book keeping sense. These flows can take various
forms. Foreign firms might accept short term claims on
firms in the country or perhaps a foreign government
extends a loan to the country.

Actual Output : The equilibrium output level provided by the intersection

Level of AD curve and Short run AS curve.

Aggregate : It shows the relation between overall price level in the

Demand Curve economy and the total output produced in the economy.

Aggregate : Aggregate supply is the total quantity of goods and

Supply services that firms produce and sell at a given price level.

Aggregate : According to classical economists, the aggregate supply

Supply Curve curve is vertical, implying that total output is always at the
full employment level. In the short run, according to
Keynes, the aggregate supply curve will be horizontal if
the economy has under-utilised resources.

Appreciation of : It is an increase in the price of domestic currency in terms

Domestic of a foreign currency.
Currency
Automatic : Revenue and expenditure items in the budget that
Stabilizers automatically change with the state of the economy and
tend to stabilize GDP.

Autonomous : Autonomous capital flows are ordinary capital flows which

Capital Flows take place regardless of other items in the balance of
payments. These flows can be caused by a foreigner
paying back a loan, or a person/ company taking up loan
abroad by issuing bonds.

Autonomous : Investment spending which is not dependent on income or

Investment interest rate.

144
Autonomous : A part of aggregate demand that is independent of income
Spending and output level.

145
Average : The ratio of consumption expenditure (C) to income (Y).
Propensity to
Consume

Badla System : Badla was an indigenous carry-forward system invented on

the Bombay Stock Exchange as a solution to the perpetual
lack of liquidity in the secondary market. Badla were
banned by the Securities and Exchange Board of
India (SEBI) in 1993, effective March 1994, amid
complaints from foreign investors, with the expectation that
it would be replaced by a futures-and-options exchange.

Balance of : It is the record of all economic transactions between the

Payments residents of a country and the rest of the world in a
particular period. These transactions are made by
individuals, firms and government bodies. Thus the balance
of payments includes all external visible and non-visible
transactions of a country.

Balance of : It is a systematic record of all its transactions (involving

Payments goods, services, physical and financial assets, as well as
transfer payments) of a country with the rest of the
countries in the world during a given period (typically one
year)

Balance of : It refers to exports and imports of visible items.

Trade

Balanced : Equilibrium income rises by the same amount by which the

Budget government spending rises. It is assumed that the change
Multiplier in government spending is equal to the change in taxes.
Taxes are taken as autonomous taxes.

Bank Rate : Rate at which the central bank lends funds to the
commercial banks.

Bond : In economics, it is an instrument of indebtedness. It is a

promise to pay its holder certain agreed upon amount of
money at specified dates in the future.

Broad Money : M3 is known as ‘broad money’ since it includes time

deposits as well.

146
Budget Deficit : When government receipts fall short of government
expenditure, we encounter the problem of budget deficit.

147
 Budget Surplus : Excess of government revenue over government spending.

Business Cycle : Periodical ups and downs in economic activity in an

economy. There are four phases of a business cycle, viz.,
expansion, recession, depression, and recovery. During
expansion phase the economy grows while during
recession there is a deceleration in growth rate. Depression
is much severe and the economy may witness negative
economic growth. During recovery, as the name suggests,
the economy recovers from depression.

Capital Account : The capital account of the BOP includes transactions

involving cross-border purchase and sale of physical and
financial assets.

Capital Account : The capital account records purchases and sales of assets
such as stocks, bonds and land, and borrowings and
lending from/ to foreigners by government , corporations
and individuals, any change in country’s gold stock or
reserves of foreign currency.

Capital Goods : These are goods which help in further production of

goods. Example could be machineries.

Cash Reserve : It is the percentage of bank deposits that the banks are
Ratio (CRR) required keep with the central bank. In India, in 2019 the
CRR is 4 percent. Thus, if Rs. 100 is deposited in a bank,
the bank needs to keep Rs. 4 with the RBI. The RBI can
vary the CRR between 3 per cent and 15 per cent.

Change in : Inventories are stocks of finished goods/ semi-finished

Inventories goods/ intermediate goods. Change in inventories is total
inventories at the end of the year minus total inventories at
the beginning of the year for an economy.

Circular Flow : It is a flow of goods or services or money from one (set

of) transactor to another (set).

Classical : Economists who subscribe to classical point of view.

Economists Eminent classical economists include Adam Smith, David
Ricardo, J B Say, and A C Pigou.

Classical Model : A model of the economy derived from ideas of the pre-
Keynesian economists. It is based on the assumption that
prices and wages adjust instantaneously to clear markets
and that monetary policy does not influence real variables

148
such as output and employment.

149
Classical View : The Classical view holds that the resources are fully
employed in all the firms and hence the manufacturing units
are working at their capacity.

Cold Turkey : It is the policy prescription of bring down inflation rate

rapidly.

Compensation : Remuneration given by enterprises to employees for

of Employees rendering labour services.

Consumer Price : Consumer Price Index represents the rate of increase in the
Index consumer prices of a basket of goods and services.

Consumption of : The capital goods wear out or fall in value as a result of its
Fixed Capital consumption or use in the production process.

Contractionary : A contractionary policy aims at slowing down the economy

Policy through a decrease in G or Ms or an increase in T. It shifts
the AD curve to the left.

Core Inflation : Core inflation is a measure of inflation that excludes items

that face volatile price movement, notably food and
energy.

Cost-push : Cost-push inflation is a sustained rise in the general price

inflation level due to a rise in the cost of production in the
economy.

Cost-push : Cost-push inflation is a sustained rise in the general price

inflation level due to a rise in the cost of production in the
economy.

Crowding Out : It reflects a situation when increase in public investment is

possible at the cost of private investment.

Currency Swap : Swaps are financial contract that obligate each party to the
contract to exchange (swap) a set of payments it owns for
another set of payments owned by another party.

Current : The current account of BOP records receipts from and

Account payments to foreigners due to international trade in goods
and services (including factor services).

Cyclical : It arises due to fluctuations in aggregate demand, which is a

Unemployment part of business cycles. When aggregate demand declines,
there is simultaneous decline in the demand for labour and
150
c ther hand, a general boom in the economy increases the
o demand for labour and unemployment decreases. Thus
n cyclical unemployment is pro-cyclical in nature.
s
e
q
u
e
n
t

i
n
c
r
e
a
s
e

i
n

u
n
e
m
p
l
o
y
m
e
n
t
.

O
n

t
h
e

151
 Deflation : Deflation is a sustained decrease in the general price level.

Demand-pull : Demand-pull inflation is a sustained rise in the general price

inflation level due to an increase in aggregate demand.

Demand-pull : It is the inflation initiated by an increase in aggregate

Inflation demand.

Depreciation : It is the loss in the value of capital asset because of

normal wear and tear and expected obsolescence.

Depreciation of : It is a decrease in the price of domestic currency in terms of

Domestic a foreign currency
Currency

Derivatives : A derivative is a security with a price that is dependent

upon or derived from one or more underlying assets. The
derivative itself is a contract between two or more parties
based upon the asset or assets. Its value is determined by
fluctuations in the underlying asset. The most common
underlying assets include stocks, bonds, commodities,
market indexes, currencies.

Devaluation : A decrease in the exchange rate under fixed exchange rate

regime implemented through government decree.

Direct : These are the taxes imposed on households in the form

Personal Taxes of income tax or wealth tax. Those on whom they are
imposed pay them.

Disposable : Amount of income received by the households after taxes

income Yd = Y – T

Double : It refers to the problem of counting the same good more

Counting than once. In order to avoid the problem, we consider the
final goods and services only.

Economic : These are groups of transactors, which indulge in

Agents economic activities like production/ income generation/
addition to capital stock. Economic agents can be
classified into producers, households, capital sector, rest of
the world, and government.

Enterprises : These are economic agents, which employ factors of

production to generate a flow of goods and services in the
economy.
152
Exchange Rate : Exchange rate between two currencies is the rate at which
one currency will be exchanged for another. It is also
regarded as the value of one country’s currency in relation
to another currency.

Exchange Rate : When a fall in the India’s price level causes India’s interest
Effect rate to fall, the real value of the rupee declines in foreign
exchange market and this depreciation stimulates Indian
net exports and thereby increases the quantity of Indian
goods and services demanded by the rest of the world.

Exchange Rate : It is how a country manages its currency in the foreign

Regime exchange market.

Expansionary : An expansionary policy aims at stimulating the economy

Policy through an increase in G or M s or a decrease in T. It shifts
the AD curve to the right.

External : ECB are loans which are raised by a country’s corporate

Commercial sector from external financial organizations on commercial
Borrowings terms.
(ECB)

Factor Cost : It is the total cost incurred to employ factors of production

to give rise to a flow of goods and services in an economy.
It is equal to value of market price minus Net Indirect
Taxes.

Factor Services : These are the services rendered by factors of production

such as land, labour, capital and enterprise.

Final : This is an expenditure incurred by households, enterprises

Consumption and rest of the world to purchase final consumer goods,
Expenditure capital goods and net exports respectively.

Financial Sector : This sector of the economy mops up savings of various

sectors and uses it for lending to other sectors of the
economy.

Fiscal Policy : It pertains to Government’s policy towards taxes and

government spending.

Fiscal Policy : The policy of a government with respect to government

expenditure and taxation.

Fixed Exchange Rate

153
: It tain a currency value that is constant against a specific
i currency or good.
s

r
e
g
i
m
e

i
n

w
h
i
c
h

g
o
v
e
r
n
m
e
n
t

t
r
y

t
o

m
a
i
n
154
Floating : Exchange rate regime wherein a currency’s value is
Exchange Rate allowed to fluctuate according to the foreign exchange
market.

Foreign : It is the buying and selling of foreign currency by the

Exchange central bank in order to influence the exchange rate.
Intervention

Foreign : These are the foreign exchange assets (e.g., foreign

Exchange currency) held by the central bank.
Reserves

Forward : In a forward contract, the buyer agrees to pay cash at a later

contract date when the seller delivers the goods. Typically, the
price at which the underline the commodity or asset will
be traded is decided at the time of entering into the
contract. Thus the price is pegged before hand to avoid the
price risk and thus assures the price at which one can buy
or sell goods at some future date.

Forward rate : Forward transactions involve the exchange bank deposit at

some specified future date- one that may be 30 days, 90
days or even several years away. The exchange rates
quoted in such transactions are called forward exchange
rates.

Fractional : Under this system, banks are required to hold a certain

Reserve fraction of their demand and time liabilities in the form of
Banking System cash balances with the central bank.

Frictional : It takes place because people switch over from one job to
Unemployment another. In many cases the tenure of job gets over and
workers remain unemployed till they get another job.

Future contract : A future contract is a standardized contract between two

parties where one of the parties commits to sell and the
other to buy, a stipulated quantity (and quality, where
applicable) of a commodity, currency, security, index or
some other specified item at an agreed price on a given
date in the future.

Goods Market : When AD and AS interact with each other. All points on the
Equilibrium IS curve reflects equilibrium in the goods market.

Government Consumption Expenditure

Final
155
 : It is the expenditure incurred by
government on the purchase of
intermediate goods plus
compensation of government
employees. This expenditure is
incurred to meet the collective
consumption of the economy.

156
Government : It is the sector, which produces goods and services that
Sector are not sold at a price. Such goods are meant to meet
collective consumption requirements of an economy. The
expenses of these goods are met by tax and non-tax
revenue of the government.

Great : The time duration when the over production and

Depression unemployment made it impossible for the world
economies to operate at equilibrium. It started in 1929 and
went on for a good 7-8 years.

Gross Domestic : It is the sum of final goods and services produced in a

Product (GDP) country during a period of time, usually a year. We do not
include intermediate goods and income acquired through
illegal activities in the GDP. In most countries, including
India, estimated value of GDP is available on a quarterly
basis as well as on a yearly basis.

Gross National : It is the value of goods and services produced in an

Product (GNP) economy over a year, without duplication but gross of
depreciation. It is the goods and services produced by the
normal residents of an economy.
High-powered
: M0 is known as monetary base or central bank money or
Money high-powered money.

Hot Money : Money which quickly moves from one nation to another in
search of speculative gains.

Household : It is the sector that supplies factor services to firms or

Sector enterprises. The factor incomes received by households
are used to meet their final consumption requirements and
the balance is used for savings, which are passed on to the
capital sector.

Hyper-Inflation : Inflation is a persistent increase in general price level.

When the rate of inflation is very high, it is said to be
hyper-inflation. Many countries have seen episodes of
hyper-inflation. In 2020, for example, Venezuela has
witnessed inflation rate 20,000 per cent per annum.

Income-Leisure : Change in income leading to a change in leisure/ labour

Trade-Off due to change in the wage rate.

157
Inflation : Inflation is a persistent increase in the general level of
prices.

158
Inflation : The objective of the monetary policy in many countries is
Targeting inflation targeting, where the central bank targets to
achieve certain inflation rate. For example, in India, the
Reserve Bank of India targets an inflation rate of 4 per
cent with a tolerance band of 2 per cent.

Inflation Tax : Financing government expenditure by printing money

increases prices for everyone, reducing their spending
power just as a tax to finance the spending would. This is
called an inflation tax.

Interest Parity : It is a condition where expected returns on deposits of any

Condition two currencies are equal when measured in the same
currency.

Interest Rate : A lower price level reduces the interest rate, encourages
Effect greater spending on investment good and thereby increases
the quantity of goods and services demanded.

Intermediate : It refers to all the goods that are used as raw material for
Goods further production of other goods.

Inventory : Demand varies periodically but production is fixed. Thus a

firm maintains certain stock of goods to meet uncertainties
in demand, supply and movement of goods. If demand
exceeds current production there is decline in the stock.
Similarly, if demand falls short of production there is
accumulation of inventory.

Investment : It is the creation of capital goods in an economy over a year.

It can be for replacement of worn out capital or for
addition to total capital stock of an economy.

Investment : It is the multiple by which income or output of an

Multiplier economy increase when investment increases by certain

1
given by the formula 𝛼 = where c stands for marginal
amount. It is
1–c
propensity to consume.

Invisible Hand : The term coined by Adam Smith, meant that government
should not intervene in the running of an economy too
often and too strongly.

159
 Involuntary : In indicates a situation where unemployment is not
Unemployment voluntary; a person is looking for a job but cannot find
one.

160
IS Curve : Investment-Saving curve showing the inverse relationship
between interest rate and income.

Keynesian View : The Keynesian view hold that the resources are under-
utilised at least in short run. The prices are sticky and
hence output can be increased without much effect on the
prices.

Labour Force : The sum of population who are willing to work, and either
employed or unemployed

Liquidity Trap : At a very low rate of interest (nearly zero), people wish to
hold any amount of money and not interested in the interest-
bearing assets.
LM Curve : Locus of the points which show the money market
equilibrium at various combinations of income and rate of
interest.
Managed
: Exchange rate regime in which the monetary authority
Floating
attempts to influence the exchange rate without having a
specific exchange rate path or target.

Marginal : Change in the output due to an additional unit of labour

Product of employed.
Labour

Marginal : The increase in consumption due to one-rupee increase in

Propensity to
consume (mpc) income. It is arrived at by calculating Y .
C

Marginal : Increase in saving due to one-rupee increase in the income.

Propensity to It is usually denoted by ‘s’ or mps.
Save
Market Price : It is the price at which a commodity or service is
actually purchased by a households or a firm.
Mixed Income
: It is the factor income generated by unincorporated
of Self-
enterprises where it is not possible to distinguish between
employed
compensation of employees and operating surplus.

Money : The money multiplier is the ratio of the stock of money to

Multiplier the stock of high powered money.

Multiplier : The amount by which the equilibrium output changes

when autonomous spending increases by one unit.

161
Multiplier Effect : The multiplier effect refers to the idea that an initial
spending rise can lead to even greater increase in national

162
 income.
Narrow Money : M1 is also known as ‘narrow money’.
Natural Rate
: It takes into account the frictions and imperfections in the
of
economy and assumes that it is natural for an economy to
Unemployment
have certain fraction of its labour force unemployed, at
any point of time. It is often termed as ‘non-accelerating
inflation rate of unemployment (NAIRU).

Net Current : It is the difference between unrequited transfers from the

Transfers from rest of the world, over a year, and such transfers from the
Rest of the economy to the rest of the world.
World

Net Domestic : It is the value of goods and services produced in an

Product (NDP) economy, over a year, without duplication, net of
depreciation. This concept is related to the concept of
domestic territory.

Net Exports : The difference between exports and imports is called net
exports or the trade balance. If exports exceed imports, the
country is said to run a trade surplus. If exports are less
than imports, the country is said to run a trade deficit.

Net Exports : It is the difference between total value of exports and

(NX) imports over a year.

Net Factor : It is the difference between factor incomes earned by the

Income from normal residents of an economy stationed abroad
Abroad temporarily and the factor incomes earned by normal
residents of the rest of the world stationed in the
economy temporarily.

Net Indirect Resident of a Country

Taxes

Nominal
Exchange Rate

Non-
Accelerating
Inflation Rate
of
Unemployment
(NAIRU)

Normal
163
: It is the difference between indirect
taxes and subsidies.

: Price of the domestic currency in

terms of the foreign currency.

: It is the abbreviation for non-

accelerating inflation rate of
unemployment. It is an
unemployment rate that is consistent
with a constant inflation rate.
NAIRU is the unemployment rate at
which the long-run Phillips curve is
vertical. It is often termed as natural
rate of unemployment.

: A person who is ordinarily resides in a

country and whose centre of
economic interest lies in that
country.

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Normal : They are the households or institutions, which have their
Residents centre of interest in the economy but some of them may
temporarily be stationed aboard.

Open Economy : It is an economy, which has economic transactions with

t he rest of the world.

Open Market : Sale/ purchase of government securities by the central bank

Operations to/ from the public and the banks.
Operating
: It is the factor income generated by ownership and
Surplus management of property. It consists of rent, interest, and
profits.

Options : The options are similar to the future contract in the sense
that they are also standardized but are different from them
in many ways. Options, in fact, represent the right but not
the obligation, to buy or sell a specified amount (and
quality) of a commodity, currency, index or financial
instrument, or to buy or sell a specified number of
underlying futures contracts at a specified price on or before
a given date in future.

Output Gap : The difference between actual output level (Actual GDP)
and the full employment level (potential output level or
potential GDP) is known as the output gap.

Per Capita GDP : The ratio of Gross domestic Product (GDP) to total
population of a country.

Phillips Curve : It shows the relationship between inflation and

unemployment. Phillips curve is downward sloping in the
short-run, implying a trade-off between the two. In the
long-run the Phillips Curve is vertical, implying that
unemployment rate cannot be brought down below natural
rate of unemployment.

Phillips curve : It is a graph named after A. W. Phillips, which shows the

trade- off between unemployment and inflation.

Potential GDP : It is the level of output (Y*) corresponding to full

employment of the labour force.

Price Level : It is the average of prices of all the goods and services
produced in a country.

Price-output : It traces out the price decisions and output decisions of all
Response Curve firms in the economy under a given set of circumstances.
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 Production : It is the relationship between factors of production (inputs)
Function and the available technology with the quantity of output
produced.

Quantity : The quantity theory of money states that there is a direct

Theory of relationship between the quantity of money in an economy
Money and the level of prices of goods and services sold.

quid pro quo : It is a Latin phrase which means an exchange relationship

between persons/ economic agents. When you get
something from a transactor in return for (in exchange of)
something, it is called quid-pro-quo.

Rate of Net : It is the difference between rate of gross domestic capital

Foreign Capital formation and rate of gross domestic savings.
Inflow

Real Exchange : Relative price of domestic goods to foreign goods.

Rate

Real Flows : These are the flows of goods or services from one set of
economic agents to another..

Real Money : Quantity of nominal money divided by the price level.

Balances

Recession : In business cycle, recession indicates the phase when there

is an economic slowdown; economic growth is in a
decelerating phase.

Relative PPP : It states that the percentage change in the exchange rate
between two currencies over any period equals the
difference between percentage changes in national price
levels.

Replacement : It is that part of currently produced capital goods, which

Investment are meant to replace the capital stock arising out of
normal wear and tear, and expectedobsolescence.

Repo Rate : Rate at which the central bank lends funds to the
commercial banks against submission of collateral such as
securities by the banks.

Residential Investment incurred on construction of new houses and

Investment buildings is called as residential investment.
:

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Rest of the : This sector deals with economic transactions of an

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World Sector economy with the rest of the world.

Revaluation : An increase in the exchange rate under fixed exchange rate

regime implemented through government decree.

Reverse Repo : Rate at which the commercial banks can deposit their
Rate excess liquidity with the central bank, by purchasing
securities.

Sacrifice Ratio : It refers to the percentage loss of output for bringing down
inflation by one per cent.

Simultaneous : Equilibrium in the goods market as well as in the money

Equilibrium market at the same time.
Slope of : It indicates the sensitivity of investment to changes in the
Investment interest rate.
Function
Spot rate : Exchange rates governing “on the spot” trading are called
spot exchange rates and the deal is called a spot
transaction.

Stagflation : Stagflation refers to an economic condition where economic

growth is very slow or stagnant and prices are rising.

Stagflation : It occurs when output is falling and at the same time prices
are rising.

Statutory : Banks are required to hold a certain percentage of their

Liquidity Ratio demand and time deposits in the form of government
(SLR) securities. Currently (in 2019) the SLR is 19.5 per cent in
India.

Structural : The supporters of structural theories believed that

theory of inflation arises due to structural maladjustments in the
Inflation county or due to certain institutional features of the
business environment.

Structural : It is the type of unemployment that arises because of

Unemployment certain structural issues in an economy. It could be due to
the mismatch between the supply of and demand for
labour in certain sectors of the economy. Educational
quality in certain sectors may not be as per industry
requirements.

Trade Surplus : A Surplus in a country’s balance of trade occurs when a

country exports more goods than it imports.
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Transfer : One-way payment of money for which no goods or
Payments services are received in exchange.

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 Value Added : It refers to the addition of value to the intermediate goods
by a firm by virtue of its productive activities.
Value of Money
The value of money is its purchasing power, the amount of
: goods and services it can buy. Value of money is inversely
related to price level. When price level increases, value of
money declines.
Value of Output : The market value of all the goods and services produced
by a firm during a financial year.

Velocity of : The number of times the money stock of turns over per year
Money in order to finance the annual flow of transactions or
income.

Wealth Effect : A decrease in the price level reduces the real value of
money and makes consumers wealthier which in turn
encourages them to spend more.

Wholesale Price : Wholesale Price Index represents the rate of increase in

Index the wholesale prices of products.

SOME USEFUL BOOKS

Abel Andrew B, Ben Bernanke, and Dean Croushore, 2017, Macroeconomics,
Ninth Edition, Pearson Education
Case Karl E., Ray C. Fair, and Sharon E. Oster, 2017, Principles of Economics,
Twelfth Edition, Pearson Education
Dornbusch Rudiger, Stanley Fisher, and Richard Startz, 2018,
Macroeconomics, Thirteenth Edition, McGraw Hill
Froyen Richard T., 2012, Macroeconomics: Theories and Policies, Tenth Edition,
Person Education
Sikdar Shoumyen, 2011, Principles of Macroeconomics, Second Edition,
Oxford University Press

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