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.
FACT ORS INFLUE NCING FOREIGN EXCHANGE R ATE: DEMAND AND SUPPLY OF FOREIGN EXCHANGE.
Which are influenced by:
1.
RATE OF INFLATION BETWEEN
DIFFERENT COUNTRIES (THE PURCHASING POWER PARITY THEORY):
current account of all countries would tend towards equilibrium. ST-SO = IF-ID SO 1+ID
Purchasing Power Parity Theory, also known as Law of one price theory, holds that over the long term, the average value of the exchange rate b/w two currencies depends upon their relative purchasing power. If a currency has a lower purchasing power in its own country, it is overvalued. This will exert a downward pressure in the local currency.
Where St = expected spot rate at time t So = current lower foreign currency spot exchange rate at time 0 if = expected inflation in foreign country to time t id = expected inflation in domestic country Moreover growth in MS affects the inflation Rate, hence exchange rates.
If a currency has a higher purchasing power in its own country, it is undervalued. This will exert an upward pressure in the local currency.
NEW EXCHANGE RATE X = OLD EXCHA NGE RATE
X × [INITIAL / FINAL] RATE OF CURRENCY Y
2.
INTEREST RATES BETWEEN DIFFERENT COUNTRIES:
High interest rates increase foreign investments, which results in increased demand for local currency by foreigners due to which the exchange rate tends to increase, but there might be the possibilities of devaluation. Link b/w Interest rates differentials and exchange rates i.e. International Fisher’s Effect, is given by: 1+rf = 1+if 1+rd = 1+id
This theory is incapable to describe short-term foreign exchange movements It is more valid in long run because the interest rate relative to other countries is certainly a factor, which influences the exchange rate. Although this influence is obvious, it is not predominant. This is 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:
Elasticity of demand for exports and elasticity of demand for imports will determine the relation b/w BoP and exchange rates. If there is persistent deficit in BoP, international confidence on currency will be eroded and causes exchange rate to fall. Moreover, the output capacity and the level of employment in the domestic economy might influence the BoP, because if the domestic economy has full employment already, it will be unable to increase its volume of production for exports
ii. AS A DESTABILIZING FACTOR: If speculators create such a high volume of demand to buy or sell currency that exchange rate fluctuates to levels where it is overvalued or undervalued, so speculation can pose a destabilizing effect on the health of economy because uncertainty about the future exchange rates will deter FDI.
5.
i.
GOVERNMENT INTERVENTIONS IN FOREIGN EXCHANGE MARKETS:
DIRECT MEASURES (OFFICIAL OR UNOFFICIAL): ii. Open Market Operations i.e. selling or buying of currency.
4.
SPECULATION:
Traders as well as investors of capital might carry speculation in a currency. When a currency is expected to devalue, debts are paid slowly in the hope that the exchange rate may fall, giving an advantage to them to pay off their debts, as 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.
INDIRECT MEASURES: By changing domestic interest rates to: Attract financial investment by raising interest rates. Discourage financial investment by lowering interest rates.
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 EXCH ANGE RATE S:
It is a policy of extremely rigid fixed exchange rates in which every Government must use its official reserves to create an exact match b/w supply and demand for its currency in the FOREX markets, in order to keep the exchange rate unchanged. Using the official reserves will thus cancel out a surplus or deficit on the current account and non-official capital transactions in their BoP. A BoP surplus would call for additions to the official reserves. A BoP deficit would call for drawings on official reserves.
2.
FREE FLOATING EXCH ANGE R ATE S:
Exchange Rates are left to the free play of market forces and there is no official financing at all. There is no need for the Government to hold any official reserves, because it will not want to use them. USAGE: Floating Exchange Rates is the only option available to the Government when all other systems break down and fail.
3.
MOV ABLE PEG:
A Movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation or revaluation of currency. ADVANTAGES OF MARGINS AROUND A MOVABLE PEG SYSTEM: A movable peg system provides some flexibility. Exchange rates, although fixed, are not rigidly fixed, because adjustments are permitted. DISADVANTAGES OF MARGINS AROUND MOVABLE PEG SYSTEM: It is still fairly inflexible, because Governments only have the choice b/w a revaluation/devaluation or holding the exchange rate steady.
The official reserves could consist of any currency or gold within the FOREX Agreement. ADVANTAGES OF FIXED EXCHANGE RATE POLICY: Removes uncertainty, thus encourage international trade. ii. Imposes economic disciplines on countries in deficit or surplus. DISADVANTAGES OF FIXED EXC HANGE RATE POLICY: i. This policy restricts independence of domestic economic policies. ii. High inflation forces a country to devalue in order to make its exports competitive and imports cheaper. i.
4.
MARGIN S AROUND MOV ABLE PEG SYSTEM:
A more flexible Movable Peg system would allow some minor variations in exchange rates.
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5. MANAGED FL OAT ING EXCH ANGE RATE SYSTEM:
It is the most prevalent exchange rate system today. In this system, a country occasionally intervenes to stabilize its currency but there is no fixed or pronounced parity. Here, the market forces basically determine exchange rates but Government buys or sell currencies or change their money supplies to affect their exchange rates. Sometimes the government leans against the winds of private markets. At other times, Government has target zones, which guide their policy actions. This system is becoming less important as countries are increasingly gravitating toward fixed or flexible exchange rates system. 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.
SUMMARY:
DETERMINANTS OF EXCHANGE RATES: DEMAND AND SUPPLY FO R CURRENC Y: 1. RATE OF INFLATION – Purchasing Power Parity Theory. 2. INTEREST RATES – High @i cause high demand for currency. 3. BALANCE OF PAYMENT – E/d of X and M affects BoP through Devaluation 4. SPECULATION – May be stabilizing or destabilizing; may also practiced by investors/traders. 5. GOVERNMENT’S INTERVENTIONS – Direct (open market operations); or Indirect (changing interest rates).
CONSEQUENCE S OF AN EXCH ANGE RATE POLIC Y:
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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