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Foreign Exchange Rates Mechanism Webs

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									                           FOREIGN EXCHANGE RATES MECHANISM

DEFINITION:

An exchange rate is the rate at which one country’s currency can be traded in exchange for another
country’s currency.

SPOT RATE: for immediate delivery.
FORWARD RATE: For delivery to be made in future.

                       FACTORS INFLUENCING FOREIGN EXCHANGE RATE:

DEMAND AND SUPPLY OF FOREIGN EXCHANGE.

Which are influenced by:

1.   RATE OF INFLATION BETWEEN                            current account of all countries would
     DIFFERENT COUNTRIES                                  tend towards equilibrium.
     (THE PURCHASING POWER          PARITY
     THEORY):                                                            ST-SO = IF-ID
                                                                           SO 1+ID
     Purchasing Power Parity Theory, also                 Where
     known as Law of one price theory, holds                St = expected spot rate at time t
     that over the long term, the average                   So = current lower foreign currency
     value of the exchange rate b/w two                            spot exchange rate at time 0
     currencies depends upon their relative                 if = expected inflation in foreign
     purchasing power.                                             country to time t
                                                            id = expected inflation in domestic
     If a currency has a lower purchasing                          country
     power in its own country, it is
     overvalued. This will exert a downward               Moreover growth in MS affects the
     pressure in the local currency.                      inflation Rate, hence exchange rates.


     If a currency has a higher purchasing power     2.   INTEREST RATES BETWEEN DIFFERENT
     in its own country, it is undervalued. This          COUNTRIES:
     will exert an upward pressure in the local
     currency.                                            High interest rates increase foreign
                                                          investments, which results in increased
     NEW EXCHANGE RATE X = OLD EXCHANGE RATE              demand for local currency by foreigners
     X × [INITIAL / FINAL] RATE OF CURRENCY Y             due to which the exchange rate tends to
                                                          increase, but there might be the
     This theory is incapable to describe                 possibilities of devaluation.
     short-term foreign exchange movements
                                                          Link b/w Interest rates differentials and
     It is more valid in long run because the             exchange rates i.e. International Fisher’s
     interest rate relative to other countries is         Effect, is given by:
     certainly a factor, which influences the
     exchange rate. Although this influence is                          1+rf = 1+if
     obvious, it is not predominant. This is                            1+rd = 1+id
     apparent from the fact that if exchange
     rates did respond to demand and supply
     for current account items, then BoP on


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3.   BALANCE OF PAYMENTS AND EXCHANGE
     RATE:                                                       ii. AS A DESTABILIZING FACTOR:

     Elasticity of demand for exports and                           If speculators create such a high
     elasticity of demand for imports will                          volume of demand to buy or sell
     determine the relation b/w BoP and                             currency that exchange rate
     exchange rates.                                                fluctuates to levels where it is
                                                                    overvalued or undervalued, so
     If there is persistent deficit in BoP,                         speculation can pose a destabilizing
     international confidence on currency will                      effect on the health of economy
     be eroded and causes exchange rate to                          because uncertainty about the future
     fall.                                                          exchange rates will deter FDI.

     Moreover, the output capacity and the
     level of employment in the domestic               5.        GOVERNMENT INTERVENTIONS IN
     economy might influence the BoP,                            FOREIGN EXCHANGE MARKETS:
     because if the domestic economy has full
     employment already, it will be unable to               i.      DIRECT MEASURES (OFFICIAL OR
     increase its volume of production for                          UNOFFICIAL):
     exports
                                                                         Open Market Operations i.e.
4.   SPECULATION:                                                         selling or buying of currency.

     Traders as well as investors of capital                ii.     INDIRECT MEASURES:
     might carry speculation in a currency.
                                                                    By changing domestic interest rates
              When a currency is expected to                       to:
               devalue, debts are paid slowly in                       Attract financial investment by
               the hope that the exchange rate                           raising interest rates.
               may fall, giving an advantage to                        Discourage financial investment
               them to pay off their debts, as                           by lowering interest rates.
               currency becomes cheaper.

              Debtors owing money in a currency,
               which is expected to appreciate in
               value, may try to pay off their debts
               before the currency becomes
               expensive, giving them financial
               disadvantage.

     Speculation may be act:

          i.    AS A STABILIZING FACTOR:

                In case of deficit, there is
                downward pressure. If speculators
                considered deficit temporary, they
                might purchase assets in the
                currency when there is Bop deficit
                and sell them, perhaps at a small
                profit, when there is surplus.




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                        EXCHANGE RATES POLICIES OF GOVERNMENTS:

1.   FIXED EXCHANGE RATES:                           2.   FREE FLOATING EXCHANGE RATES:

      It is a policy of extremely rigid fixed              Exchange Rates are left to the free
      exchange rates in which every                        play of market forces and there is no
      Government must use its official                     official financing at all. There is no
      reserves to create an exact match b/w                need for the Government to hold any
      supply and demand for its currency in                official reserves, because it will not
      the FOREX markets, in order to keep                  want to use them.
      the exchange rate unchanged. Using
      the official reserves will thus cancel               USAGE:
      out a surplus or deficit on the current
      account and non-official capital                     Floating Exchange Rates is the only
      transactions in their BoP.                           option available to the Government
                                                           when all other systems break down
              A BoP surplus would call for                and fail.
               additions to the official reserves.
              A BoP deficit would call for          3.   MOVABLE PEG:
               drawings on official reserves.
                                                           A Movable or adjustable peg system is
      The official reserves could consist of               a system of fixed exchange rates, but
      any currency or gold within the FOREX                with a provision for the devaluation or
      Agreement.                                           revaluation of currency.
      ADVANTAGES OF FIXED EXCHANGE RATE                    ADVANTAGES OF MARGINS AROUND A
      POLICY:                                              MOVABLE PEG SYSTEM:

      i.  Removes uncertainty, thus                          A movable peg system provides
          encourage international trade.                     some flexibility. Exchange rates,
      ii. Imposes economic disciplines on                    although fixed, are not rigidly fixed,
          countries in deficit or surplus.                   because adjustments are permitted.
      DISADVANTAGES OF FIXED EXCHANGE                      DISADVANTAGES OF MARGINS AROUND
      RATE POLICY:                                         MOVABLE PEG SYSTEM:
      i.  This policy restricts independence                 It is still fairly inflexible, because
          of domestic economic policies.                     Governments only have the choice
      ii. High inflation forces a country to                 b/w a revaluation/devaluation or
          devalue in order to make its                       holding the exchange rate steady.
          exports competitive and imports
          cheaper.
                                                     4.   MARGINS AROUND MOVABLE PEG
                                                          SYSTEM:

                                                          A more flexible Movable Peg system
                                                          would allow some minor variations in
                                                          exchange rates.




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5. MANAGED FLOATING EXCHANGE RATE                SUMMARY:
   SYSTEM:
                                                 DETERMINANTS OF EXCHANGE RATES:
    It is the most prevalent exchange rate
    system today. In this system, a country      DEMAND AND SUPPLY FOR CURRENCY:
    occasionally intervenes to stabilize its
    currency but there is no fixed or               1. RATE OF INFLATION – Purchasing Power
    pronounced parity.                                 Parity Theory.

    Here, the market forces basically               2. INTEREST RATES – High @i cause high
    determine exchange rates but                       demand for currency.
    Government buys or sell currencies or
    change their money supplies to affect           3. BALANCE OF PAYMENT – E/d of X and M
    their exchange rates.                              affects BoP through Devaluation

    Sometimes the government leans                  4. SPECULATION – May be stabilizing or
    against the winds of private markets. At           destabilizing; may also practiced by
    other times, Government has target                 investors/traders.
    zones, which guide their policy actions.
    This system is becoming less important          5. GOVERNMENT’S INTERVENTIONS –
    as countries are increasingly gravitating
    toward fixed or flexible exchange rates               Direct (open market operations);
    system.                                                or
                                                          Indirect (changing interest rates).
    Through this system, the currency of a
    country is not allowed to freely float in
    the international market or in other
    words, the country adopting this system
    is not allowed to determine the value of
    its currency by the free and unfettered
    forces of demand and supply of foreign
    exchange.

    This system is adopted by Pakistan on
    8th January 1982 and is managed by
    SBP.

CONSEQUENCES OF AN EXCHANGE RATE
POLICY:

   1. Rectify the BoP deficit by falling Ex.
      Rate.
   2. Prevent BoP surplus by raising Ex.
      Rate.
   3. Emulate economic conditions in other
      countries.
   4. To stabilize Ex. Rates for building
      confidence of exporters/importers.




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