Factor Affecting exchange rate and Theories of exchange rate

It explains the following topics
Factor Affecting the exchange rate
CURRENCY DEPRECIATION VS.CURRENCY APPRECIATION
Foreign exchange
Theories of exchange rate

1. •FACTORS
AFFECTING
EXCHANGE RATE
•THEORIES OF
EXCHANGE RATE
▪Submitted By:
▪005 Manpreet
▪041 Jatin Goyal
▪044 Mehak Rastogi
▪059 Shivani Mukhija
Submitted To:
Dr. Phool Chand

2. •ForeignExchangereferstothemechanismofthewaysandmeansbywhich
paymentinconnectionwithInternationalTradeareeffected.Itreferstoall
currenciesotherthanthedomesticcurrencyofagivencountry.
•ExchangeRate:Therateofexchangeisthepriceofonecurrencyexpressed
intermsofanothercurrency,itisthereflectionoftheexternalvalueofthe
domesticcurrency.
•Itshouldalsobenotedherethatexchangerateisnotalwaysconstant,itgoes
onchangingfromtimetotimeoaccountofchangeindemandforandsupply
offoreigncurrency.

3. 1.Differentials inInflation
2.Differentials in InterestRates
3.Balance of Payment
4.Government Debt
5.Terms of Trade
6.Monetary Policy
7.Economic Strength
8.ResourceDiscovery
9.Speculation
10.Recession
11.Market Factor
12.Political Stability And
EconomicPerformance

4. CURRENCY DEPRECIATION VS.CURRENCY APPRECIATION
▪CURRENCYAPPRECIATION
I.Itreferstoincreaseinthevalueof
domesticcurrencyintermsof
foreigncurrency.
II.Itmakesforeigngoodscheaperin
domesticcountryasmoreand
moreofgoodscannowbe
purchasedwithsameamountof
domesticcurrency.So,itleadsto
increaseinimports.
III.Achangefrom$1=60to
▪$1=55representsthatIndian
Rupeesisappreciating.
CURRENCY DEPRECIATION
I.Itreferstodecreaseinthevalueof
domesticcurrencyintermsof
foreigncurrency.
II.Itmakesdomesticgoodscheaper
inforeigncountryasmoreand
III.
moreofgoodscannowbe
purchasedwithsameamountof
foreigncurrency.So,itleadsto
increaseinexports.
Achangefrom$1=55to$1=60
representsthatIndianRupeesis
depreciating.

5. It refers to the rate at which one currency is exchanged forthe
other.
It represents the price of one currency in terms ofanother
currency.
Types-
1.Fixed exchange ratesystem
2.Flexible exchange ratesystem
3.Managed floating ratesystem

6. It refers to a system in which exchange rate for a currency is fixed by the
government.
Basic purpose of adopting this system is to ensure stability in foreign trade and
capitalmarket.
Under this system, each country keeps value of its currency fixed in terms of
some ‘externalStandard’.
•Itreferstoasysteminwhichexchangerateisdeterminedbyforcesof
demand and supply of different currencies in foreign exchangemarket.
•There is no official (government) intervention in foreign exchangemarket.
•Also known as ‘floating exchangerate’.

7. Itreferstoasysteminwhichforeignexchangerateisdetermined
bymarketforcesandcentralbankinfluencestheexchangerate
throughinterventioninforeignexchangemarket.
Itisahybridofafixedexchangerateandaflexibleexchangerate
system.
Aimistokeepexchangerateclosetodesiredtargetsvalue.
Alsoknownas‘Dirtyfloating’.

8. The demand (or outflow) of foreign exchange comes from those
people who need it to make payment in foreigncurrency.
It is demanded by the domestic residents for the following reasons:
1.Imports of Goods andservices.
2.Tourism
3.Unilateral transfer sentabroad
4.Purchase of assets in foreigncountries
5.Speculation

9. DEMAND CURVE OF FOREIGN EXCHANGE SLOPES DOWNWARDS
DUE TO INVERSE RELATIONSHIPS BETWEEN DEMAND FOR
FOREIGN EXCHANGE AND FOREIGN EXCHANGE RATE.

10. Thesupply(orinflow)offoreignexchangecomesfromthose
people who receive it due to followingreasons.
1.Exports of Goods andservices.
2.Foreigninvestment
3.Unilateral transfer fromabroad
4.Speculation

11. SUPPLYCURVEOFFOREIGN EXCHANGE SLOPESUPWARDS DUE
TOPOSITIVERELATIONSHIPS BETWEEN SUPPLYFORFOREIGN
EXCHANGE ANDFOREIGNEXCHANGE RATE.

12. Exchange rate is
determined by the
interactionof theforces
of demand andsupply.
The equilibrium
exchange rate is
determined at a level
where demand for
foreign exchange is
equal to the supplyof
foreignexchange.

13. •IftheexchangeraterisestoOR₂,thendemandforforeign
exchangewillfallfromOQ₂andsupplywillrisetoOQ₁.Itwill
beasituationofexcesssupply.Asaresult,exchangeratewill
falltillitagainreachestheequilibriumlevelofOR.
•Iftheexchangeratefallstoor₁,thendemandforforeign
exchangewillrisefromoq₁andsupplywillfalltooq₂.Itwillbe
asituationofexcessdemand.Itwillpushuptheexchangerate
tillitreachesOR.

17. ▪Law of one price
▪dollar price of good iis the same
wherever it is sold (E
PPP
$/€= P
US/P
E)
▪Theory of Purchasing Power Parity
▪Absolute Purchasing power Parity
▪Relative Purchasing power parity
▪Interest Rateparity
▪Coveredinterest rate parity
▪Uncovered Interest rate parity
▪InternationalFisherEquation
▪Monetary Models of Exchange rate
▪SebastianEdwardModel of Exchange
rate

18. Law of one price
dollar price of good iis the same wherever it is sold (E
PPP
$/€= P
US/P
E)

19. ▪Theory of Purchasing Power Parity (PPP)
▪The exchange rate between two counties’ currencies equals the
ratio of the counties’ price levels.
▪It compares average prices across countries.
▪It predicts a dollar/euro exchange rate of:
E
PPP
$/€= P
US/P
E
where:
P
USis the dollar price of a reference commodity
basket sold in the United States
P
Eis the euro price of the same basket in Europe

20. Co
pyr
igh
t ©
200
3
Pea
rso
n
Ed
▪Absolute PPP and Relative PPP
▪Absolute PPP
▪It states that exchange rates equal relative price levels.
▪Relative PPP
▪It states that the percentage change in the exchange rate between two currencies
over any period equals the difference between the percentage changes in national
price levels.
▪Relative PPP between the United States and Europe would be:
(E
$/€,t -E
$/€, t–1)/E
$/€, t–1 = 
US, t -
E, t
where:

t = inflation rate

21. Covered Interest Rate Parity

22. Un-Covered Interest Rate Parity

25. DEMAND AND SUPPLY
OF EXCHANGE RATE
GROWTH THEORY OF
EXCHANGE RATE
BALANCE OF
PAYMENT(BOP) THEORY
OF EXCHANGE RATE