exchange rate & its economic effects

EXCHANGE RATE & ITS ECONOMIC EFFECTS

Dr C Anirvinna

CA Course

Paper No. 8B - Economics for Finance

Exchange rate

At the end of this unit, you will be able to:

o Define exchange rate and describe how it is determined

o Appraise different types of exchange rate regimes

o Describe the functioning of the foreign exchange market

oExplain changes in exchange rates and their impact on thereal

economy

Exchange rate• Exchange Rate : at which currency of one country gets exchanged with currency

of other country. Two variants Nominal vs Real Exchange rate.

• Nominal Exchange Rate : How many units of domestic currency is required to buy

one unit of foreign currency. Rs 75 required to buy 1 USD

• Real Exchange rate: It is the relative prices of goods and services in both

domestic and foreign country. It is the rate at which goods are traded between

two countries.

• Real Exchange Rate (E) = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑒 𝑋 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑔𝑜𝑜𝑑𝑠

𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑔𝑜𝑜𝑑𝑠

• = 𝑒 𝑥 𝑝

𝑝∗

• If real exchange rate is high means: Answer me

Exchange rate

• If real exchange rate is high means: Price of foreign goods is cheaper than price of

domestic goods. This means Imports will raise and exports will fall leading to Nx

will be negative resulting in Current account deficit (CAD)

• If real exchange rate is low means opposite that is Nx will be positive and Current

Account Surplus

• REAL EXCHANERATE CURRENT

ACCOUNT

High Deficit

Low surplus

Exchange rate

➢ Thus Real exchange rate depends upon the

➢ Nominal Exchange rate

➢ Ratio of price level

Nominal Exchange rate

Nominal exchange rate =Real exchange rate x 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑔𝑜𝑜𝑑

𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑑𝑜𝑒𝑚𝑠𝑡𝑖𝑐 𝑔𝑜𝑜𝑑

Exchange rate

➢ US car costs =$ 10,000➢ Indian car costs = Rs 960,000➢ To compare the prices of 2 cars we have to convert them into a

common the prices of 2 cars we have to convert them into a common currency

➢ Assume 1$ =Rs 48 in this case➢ Then US car costs 10000x48 = 48,0000➢ Indian car costs =960,0000➢ US car costs just half the price of Indian car and we can exchange 2

US cars for 1 Indian car

DIRECT QUOTE VS INDIRECT QUOTE

➢ The most basic explanation of indirect and direct quotes is that they are part of currency pairs that we see

on our trading terminals. The only thing that we need to consider when looking at them is where we are

located geographically or the native currency that we are using.

➢ For example, if you are from the United States, your native currency is the United States Dollar. In this case,

the USD/EUR currency pair would be considered a direct quote for you. Why? Because the first currency in

the pair (base currency) is your native currency. This means that you can directly calculate how many Euros

you can buy with 1 USD.

➢ So if the USD/EUR currency pair has an exchange rate of 0.9083 this means that 1 USD will get you 0.9 EUR.

However, if you were from Europe and your native currency was the Euro, then the USD/EUR currency pair

would be an indirect currency quote for you. You would have to do some calculating to determine how much

USD one Euro would get you.

➢ It’s usually advised to trade with direct quotes because it’s easy to immediately understand how much

you’re trading and how much to expect as a payout. With indirect quotes, you’d have to use equations to

determine the accurate amount.

Real Effective Exchange Rate and Cross Rate

➢Real Effective Exchange Rate

➢The Real Effective Exchange Rate (REER) is an indicator of external competitiveness of a

country ‘s currency . It is the weighted average of country’s currency against a basket of

other major currencies (after adjusting for inflation differentials)

➢An increase in REER implies that exports become more expensive, and imports

become cheaper; therefore, an increase indicates a loss in trade competitiveness

and vice versa

➢Cross Rate

➢Generally, all countries currencies are priced in $ US

➢Any exchange rate if does not involve the $US then it is called cross rate

➢AUDNZD, EURJPY, EURGBP

Exchange rate regimes

• An exchange rate regime is the system by which a country manages its currencywith respectto foreign currencies. . There are two major types of exchange rate regimes at the extreme ends;namely:

• Fixed vs Flexible/ Floating exchange rates

• Fixed Exchange rate : If the Value of the currency is pegged against US Dollar by the Government of the country. The value will not change frequently but value changed by the Government as and when required but not to the extent of actual requirement. These countries keep value of currency artificially low so that their exports remain high. Very few countries follow Fixed Currency.

• Example It is used by China. 1 Yuan = 0.50 USD.

• in order to maintain the exchange rate at the predetermined level, the central bank intervenesin the foreign exchange market. It will sell the $ if the value is lesser and vice versa if the value is higher

CAUSES OF FISCAL DEFICITPersistent Revenue Deficit Lack of RevenuesCountry is in developing state2. CONSEQUENCES OF FISCAL DEFICIT1. Downgrading of the economy (Moody, S&P etc.). 2. Capital Flys Once they downgrade the economy, the capital will fly (FIIs) out of country. 3. Rupee Depreciation This means rupee depreciation due to excess supply of INR. 4. Expensive Imports & Cheaper Exports This means imports of goods and services becomes costly/expensive and exports of goods and services become cheaper (competitive).

CLASS 15 08/01/20205. Inflation If Rupee depreciates, Imports of oil become expensive as oil prices go up. It get reflected in CPI (Consumer Price Index for Inflation). CPI will raise. This means inflation. 6. Repo Rate RBI will increase the Repo Rate to control the inflation. This will lead to fall in investment -> Fall in output -> Fall in employment -> Fall in income -> Fall in Government Revenues -> Further increase in fiscal deficit

DEVALUATION /REVALUTION vs Depreciation and Appreciation

➢ DEVALUATION Vs REVALUATION

➢countries which follow fixed exchange rate if they deliberately reduce the value of

currency then it is called devaluation . On the other hand if countries increase the

value of currency then it is called revaluation. It happens with the intervention of the

government

➢DEPRECIATION Vs APPRECIATION

➢Countries which follow flexible exchange rate system their currency may get

depreciated or appreciated against the US $. It happens without central bank

intervention


• In reality majority of countries follow flexible exchange rate where in exchange rate is determined by the market but in case the exchange rate deviates the band ( say Rs 70 -75 ) and

• if it becomes 76,77,78 then it is called depreciation on the other hand if it becomes 69,68, 67 then it is called rupee appreciation) then RBI will intervene then it is soft peg exchange rate policy

• Hard peg exchange rate policy refers to that a country follows fixed exchange rate and keeps the value unchanged. The central bank will intervene only when as and when required

• Advantages of Fixed Exchange rate

1. A fixed exchange rate avoids currency fluctuations and eliminates exchangerate risks and transaction costs that can impede international flow of trade and investments

2. A fixed exchange rate can thus, greatly enhance international trade and investment

3. A reduction in speculation on exchange rate movements if everyonebelieves that exchange rateswill not change.


4. A fixed exchange rate system imposes discipline on a country’s monetaryauthority and therefore is more

likely to generate lower levels of inflation

5. Exchange rate peg can also enhance the credibility of the country’smonetary-policy.

6.The government can encourage greater trade and investment as stability encourages investment

• Flexible Exchange rate system

• If exchange rate system is determined by market forces of demand and supply then it is called flexible or floating exchange rate system. Majority of the countries follow flexible exchange rate system which is considered to be efficient and transparent .

• Advantages of Flexible exchange

1. It allows central bank to follow its independent Monetary policy

2. Floating exchange rate regime allows exchange rate to be used as a policytool: for example, policy-

makers can adjust the nominal exchange rate toinfluence the competitiveness of the tradable goodssector


3. As there is no obligation or necessity to intervene in the currency markets,the

central bank is not required to maintain a huge foreign exchange reserves.

4. However, the greatest disadvantage of a flexible exchange rate regime is that

volatile exchange rates generate a lot of uncertainties in relation to international

transactions and add a risk premium to the costs of goods and assets traded

across borders.

5. In short, a fixed rate brings in more currency and monetary stability and

credibility; but it lacks flexibility. On the contrary, a floating rate has greater policy

flexibility; but less stability

The Foreign Exchange Market

➢ The foreign exchange market or forex market or currency market is over

counter global market place that determines the exchange rate for currencies

around the world.

➢The participants are central banks, commercial banks, governments, foreign

exchange Dealers, MNCs that engage in international trade and investments,

non-bank financial institutions such as asset-management firms, insurance

companies, brokers, arbitrageurs and speculators

➢ The role of central bank is to take care of exchange rate of their respective

currency to ensure appreciation or depreciation are happening at the desired limits.

Both appreciation and depreciation cause havoc on the national income hence need

for stable currency’


➢ The commercial banks participate in the foreign exchange market either on theirown account

or for their clients. When they trade on their own account, banksmay operate either as

speculators or arbitrageurs/or both. The bulk of currency transactions occur in the interbank

market in which the banks trade with eachother.

➢ Foreign exchange brokers participate in the market as intermediaries between different dealers or

banks.

➢ Arbitrageurs make profit by discovering price differences between pairs of currencies with

different dealers or banks.

➢ Speculators, who are bulls or bears, are deliberate risk-takers who participate inthe market to

make gains which result from unanticipated changes in exchangerates.

➢ Other participants in the exchange market are individuals who form only avery insignificant

fraction in terms of volume and value of transactions

➢ Regardless of physical location, and given that the markets are highly integrated,at any given

moment, all markets tend to have the same exchange rate for a given currency. This

phenomenon occurs because of arbitrage


In the foreign exchange market, there are two types of

transactions:

1) current transactions which are carried out in the spot market

and the exchange involves immediate delivery, per current

exchange rate

2) future transactions wherein contracts are agreed upon to buy

or sell currencies for future delivery which are carried out in

forward and/or futures markets

The Functions of Foreign Exchange Market

➢ High Liquidity

It is the most liquid financial market in the whole world involving trading of various

currencies of the world

➢Market Transparency

Traders have complete access to the market information of different market

currencies

➢ Dynamic Market

It is the dynamic market since the value of currency keeps changing on every second

and hour

➢ 24 hours

It operates 24 hours to facilitate the trade among traders at any time

Determination of Nominal Exchange Rate

• WHY Individuals, Institutions and government DEMAND US DOLLARS?? (DEMAND)

• Foreign Education (for paying university fee)

• Foreign Direct Investment (FDI) (Long Term) (Equity)

• FII (Equity and Bonds)

• Tourism

• Buying Foreign Goods and Services

• Imports

• HOW Individuals/ institutions/ government GET US DOLLARS?? (SUPPLY)

• Exports of goods and services

• Tourists visiting India

• FII (Equity and Bonds)

• FDI

Determination of Nominal Exchange Rate

Changes in exchange rate- Home currency Depreciation

Changes in exchange rate- Home currency appreciation

Depreciation or Appreciation of currency and Dirty Float

Why depreciation or Appreciation of currency are both bad for a currency.

• Why is appreciation bad?? Exports will become expensive (uncompetitive) and Imports

become cheaper. When Imports g&s more than Exports g &s (M>E), this leads to Current

Account Deficit.

• Why is depreciation bad?? Exports become cheaper and Imports become costly. When

Exports g&s more than Imports g & s (E>M), this may lead to Current Account Surplus

Dirty Float

In reality many countries follow flexible exchange rate system but what they follow is dirty

float.

RBI creates band 72-76

FACTORS DETERMINING THE EXCHANGE RATE1. CAPITAL FLOWS

• Everyday capital is moving from India to other countries (say USA) and vice versa. Capital means FIIs. FDI is Long Term Investment and hence FDI doesn’t move fast unlike FIIs.

• Assume Capital coming into India (Capital inflows) is more than the capital flowing (Capital outflows) out of India. Rupee gets appreciated. If Capital outflows are more than capital inflows, rupee depreciates.

2. PURCHASE POWER PARITY

• Example 1 Pound Sterling = INR 80 /-

• Assume one pair of branded shoes cost Rs. 400 /- in India. Same shoes should cost 5 Pound Sterling in UK. Whether we purchase shoes in India or UK, cost should be the same. In case shoe price is 3 UK pounds. Indians would buy more from UK. Pound would appreciate and Rupee depreciate.

FACTORS DETERMINING THE EXCHANGE RATE3. SHORT TERM INTEREST RATE (REPO RATE)

• If Repo rate in India is higher than Short Term Interest Rate in USA. Investors are going to take their money out of US Market and park their money in India in form of bonds and equity. Then, rupee value appreciates and US $ will appreciate

4. INFLATION

• If inflation rate in India is higher than US Dollar. There is a possibility that capital may fly from India to USA.

5. FISCAL DEFICIT

• If Fiscal deficit is high for any country, credit rating agencies in USA like S&P will downgrade the economy. Investors will take their money out of the country. Rupee value depreciates.

6. CURRENT ACCOUNT DEFICIT

• Imports of Goods & Services more than Exports. Credit Rating agencies in USA like S&P will downgrade the economy. Investors . Both Fiscal Deficit and Current Account Deficit is called Twin Deficit Problem.

IMPACT OF EXCHANGE RATE FLUCTATIONS ON INDIAN ECONOMY

1. It plays a major role in international trade of exports and imports. Appreciation of currency

may hurt exports and benign on imports

2. if currency depreciates the exports may become cheaper and competitive in the world market

which may be counter balanced costlier exports due to depreciation of rupee

3. If currency depreciates the cost of repayment of debt of corporates and government will go up

4. If currency depreciates the cost of imported raw materials and inputs would go up for

developing /under developed countries resulting increased in cost of production fall in real

output

5. If currency depreciates the cost of two major imports namely oil and gold will go up


6. If currency depreciates then the price of foreign goods may become expensive then people in the

country would rather prefer to buy domestic goods then the demand for domestic goods would go

up resulting in expansionary effect such as output, employment investment and income. This will

work on the assumption only if people switch to domestic goods over foreign goods.

7. Foreign Portfolio investors will take out their investment if rupee volatility is high . These investors

have invested in equity and bond markets.

8. Exchange rate fluctuations will make firms difficult to forecast their cost and revenue and have to

undergo a lot of risk and uncertainty. They have no option but to hedge their risk which involves

again huge cost.

9.Indian firms avoid hedging considering the cost involved in it. But when they borrow under ECB

will have a lot of difficulties at the payment of repayment debt if currency depreciates against the $

. There would be undue pressure on RBI’s foreign exchange reserves


10. If rupee depreciates against the $ the inflation rate (CPI) will go up as well since CPI includes goods which are imported

11. If rupee appreciates the exports become expensive and imports costly resulting lesser exports of goods and services in comparison with more imports of goods and services resulting in current account deficit. The current deficit will reflect that the country is not in a position to pay for its import bill

12 . Depreciation of currency may help India to contain the import of gold which helps to control to Trade balance

13. Depreciation of currency may help the economy to control trade deficit with exports cheaper and imports costly

14. An appreciation of currency would help to control imported inflation especially items like oil and gold making them cheaper

15.If rupee depreciating then RBI will have to use its special foreign exchange reserves to protect the rupee against the $ by selling $

True or False questions

1. All flexible countries follow dirty float

2. If rupee depreciates RBI purchases the $

3. Real exchange is low it means foreign goods are expensive

4. Purchasing power parity determines the exchange rate

5. Repo rate is linked to exchange rate

Essay Questions

1. Discuss the different times of exchange rate regimes

2. How is exchange rate is determined under floating exchange rate

system? How changes in exchange affect the home country?

3. What are the various determinants of exchange rate system?

4. Differentiate between nominal and real exchange rate system? How

do you determine the strength of a currency?

5. Write a note on forex market

6. Discuss the advantages of fixed and flexible exchange rate systems

THANK YOU

exchange rate & its economic effects

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