Lecture 12 - Exchange Rate | Macroeconomics- Learning and Analysis PDF Download

 Page 1


Exchange Rate 
Institute of Lifelong, University of Delhi 
 
 
 
 
Subject: Macroeconomics 
Lesson: Exchange Rate 
Lesson Developer: Supriti Mishra  
College/ Department: Shyam Lal College, University of Delhi 
  
Page 2


Exchange Rate 
Institute of Lifelong, University of Delhi 
 
 
 
 
Subject: Macroeconomics 
Lesson: Exchange Rate 
Lesson Developer: Supriti Mishra  
College/ Department: Shyam Lal College, University of Delhi 
  
Exchange Rate 
Institute of Lifelong, University of Delhi 
1.  
2. Learning outcomes 
3. Introduction  
4. Concept of exchange rate 
5. History and evolution of exchange rate 
6. Fixed versus flexible exchange rate 
6.1  Fixed Exchange Rate 
6.2 Advantages Of Fixed Exchange Rate System  
6.3 Disadvantages Of Fixed Exchange Rate System  
6.4  Flexible Exchange Rate 
6.5 Advantages of Flexible Exchange Rate System  
6.6 Disadvantages of Flexible Exchange Rate System  
7. Determinants of exchange rate 
8. Foreign exchange market 
7.1Functions of Foreign Exchange Market 
      7.2Spot and forward exchange rate 
7.3 Demand for exchange rate 
      7.4Supply of exchange rate 
7.5 Equilibrium exchange rate  
8 Changes in the exchange rate 
9 Purchasing Power Parity Theory of Exchange Rate Determination                (PPP 
THEORY) 
9.1Criticism of PPP theory 
10  Foreign exchange reserves in India 
11 Summary 
12 Exercise 
13 Glossary 
14 References  
1. Learning outcomes: 
After reading this chapter, you will be able to: 
- define the concept of exchange rate 
- describe the historical perspectives of the exchange rate 
- differentiate between fixed exchange rate and flexible exchange rate  
- know how exchange rate is determined in the free market 
Page 3


Exchange Rate 
Institute of Lifelong, University of Delhi 
 
 
 
 
Subject: Macroeconomics 
Lesson: Exchange Rate 
Lesson Developer: Supriti Mishra  
College/ Department: Shyam Lal College, University of Delhi 
  
Exchange Rate 
Institute of Lifelong, University of Delhi 
1.  
2. Learning outcomes 
3. Introduction  
4. Concept of exchange rate 
5. History and evolution of exchange rate 
6. Fixed versus flexible exchange rate 
6.1  Fixed Exchange Rate 
6.2 Advantages Of Fixed Exchange Rate System  
6.3 Disadvantages Of Fixed Exchange Rate System  
6.4  Flexible Exchange Rate 
6.5 Advantages of Flexible Exchange Rate System  
6.6 Disadvantages of Flexible Exchange Rate System  
7. Determinants of exchange rate 
8. Foreign exchange market 
7.1Functions of Foreign Exchange Market 
      7.2Spot and forward exchange rate 
7.3 Demand for exchange rate 
      7.4Supply of exchange rate 
7.5 Equilibrium exchange rate  
8 Changes in the exchange rate 
9 Purchasing Power Parity Theory of Exchange Rate Determination                (PPP 
THEORY) 
9.1Criticism of PPP theory 
10  Foreign exchange reserves in India 
11 Summary 
12 Exercise 
13 Glossary 
14 References  
1. Learning outcomes: 
After reading this chapter, you will be able to: 
- define the concept of exchange rate 
- describe the historical perspectives of the exchange rate 
- differentiate between fixed exchange rate and flexible exchange rate  
- know how exchange rate is determined in the free market 
Exchange Rate 
Institute of Lifelong, University of Delhi 
- describe the factors which affect the equilibrium exchange rate 
- understand how PPP theory determines the exchange rate 
2. Introduction 
In today’s time, self sufficiency of any nation does not exist and dependency on other nations 
for its internal requirement is un-deniable. A country chooses cheaper import option for 
fulfillment of internal requirement of goods and services which are not produced within the 
country. In the same manner, a country balances by exporting services and goods to other 
countries which it can supply with relative benefit. In this manner international expertise is 
achieved which is advantageous to all countries in a trade free world. In international trade, 
Problems arise as different currencies exercise exchange as a medium to use different 
currencies. This problem is primarily due to buyers and sellers belonging to multiple nations. If 
an Indian buyer is purchasing a product from a seller who is an American, then buyer is liable to 
make payment in US dollars because payment in rupees would not come under accepted norms 
of US firm. Smooth business transaction between two countries can happen through mode of 
currencies exchange. 
3. Concept of Exchange Rate 
Exchange rate is defined as the price at which one unit of currency can be exchanged for the 
number of units of currency of another country. Exchange rate is a representative of a 
currency’s price in terms of another currency. In other words, it is the price paid for buying one 
unit of foreign currency through domestic currency. There are two ways in which it can be 
expressed: 
? The units of domestic currency required to purchase one unit of foreign currency, e.g., $ 
1=Rs. 50. 
? The units of foreign currency that can be purchased in exchange for a unit of domestic 
currency, e.g., Re. 1 = 2 cents. 
In both the ways, exchange rate is a representative of purchasing muscle of domestic currency 
in form of foreign currencies. A rise in the peripheral value of the domestic currency i.e., an 
increase in exchange rate is said as an appreciation of the domestic currency. For e.g., 
suppose formerly 50 rupees were required to buy a dollar, now only 45 rupees are sufficient to 
buy a dollar. This implies that the cost of the rupee in terms of dollar has improved. As a result, 
rupee has appreciated.  A plunge in the external value of the domestic currency i.e., a fall in 
exchange rate is called a depreciation of the domestic currency. For e.g., if earlier 50 
rupees were sufficient to buy a dollar now 55 rupees are essential to buy a dollar. This implies 
that the value of the rupee in terms of dollar has lowered. Accordingly, rupee has depreciated. 
There are two types of Exchange Rates: nominal and real exchange rate. Nominal exchange 
rate defines the purchasing strength of domestic currency in terms of overseas currency. It 
reflects movement when price level changes in either of the two countries. Alternatively, Real 
exchange rate is the hypothetical exchange rate attuned for the inflation disparity between the 
two countries. For example, if A country has an inflation rate of 10%, country B has inflation 
rate of 5% and nominal rate of exchange remains unchanged, then actual price of country A 
currency is at present 10%-5%= 5% higher than before. Higher prices signify an appreciation 
of the actual exchange rate. 
4. History and Evolution of Exchange Rate 
The importance of the gold standard is highlighted in 19
th
 century. Between 1876 and 1913, the 
system of exchange rate was reliant on the individual currency’s relative convertibility to gold’s 
Page 4


Exchange Rate 
Institute of Lifelong, University of Delhi 
 
 
 
 
Subject: Macroeconomics 
Lesson: Exchange Rate 
Lesson Developer: Supriti Mishra  
College/ Department: Shyam Lal College, University of Delhi 
  
Exchange Rate 
Institute of Lifelong, University of Delhi 
1.  
2. Learning outcomes 
3. Introduction  
4. Concept of exchange rate 
5. History and evolution of exchange rate 
6. Fixed versus flexible exchange rate 
6.1  Fixed Exchange Rate 
6.2 Advantages Of Fixed Exchange Rate System  
6.3 Disadvantages Of Fixed Exchange Rate System  
6.4  Flexible Exchange Rate 
6.5 Advantages of Flexible Exchange Rate System  
6.6 Disadvantages of Flexible Exchange Rate System  
7. Determinants of exchange rate 
8. Foreign exchange market 
7.1Functions of Foreign Exchange Market 
      7.2Spot and forward exchange rate 
7.3 Demand for exchange rate 
      7.4Supply of exchange rate 
7.5 Equilibrium exchange rate  
8 Changes in the exchange rate 
9 Purchasing Power Parity Theory of Exchange Rate Determination                (PPP 
THEORY) 
9.1Criticism of PPP theory 
10  Foreign exchange reserves in India 
11 Summary 
12 Exercise 
13 Glossary 
14 References  
1. Learning outcomes: 
After reading this chapter, you will be able to: 
- define the concept of exchange rate 
- describe the historical perspectives of the exchange rate 
- differentiate between fixed exchange rate and flexible exchange rate  
- know how exchange rate is determined in the free market 
Exchange Rate 
Institute of Lifelong, University of Delhi 
- describe the factors which affect the equilibrium exchange rate 
- understand how PPP theory determines the exchange rate 
2. Introduction 
In today’s time, self sufficiency of any nation does not exist and dependency on other nations 
for its internal requirement is un-deniable. A country chooses cheaper import option for 
fulfillment of internal requirement of goods and services which are not produced within the 
country. In the same manner, a country balances by exporting services and goods to other 
countries which it can supply with relative benefit. In this manner international expertise is 
achieved which is advantageous to all countries in a trade free world. In international trade, 
Problems arise as different currencies exercise exchange as a medium to use different 
currencies. This problem is primarily due to buyers and sellers belonging to multiple nations. If 
an Indian buyer is purchasing a product from a seller who is an American, then buyer is liable to 
make payment in US dollars because payment in rupees would not come under accepted norms 
of US firm. Smooth business transaction between two countries can happen through mode of 
currencies exchange. 
3. Concept of Exchange Rate 
Exchange rate is defined as the price at which one unit of currency can be exchanged for the 
number of units of currency of another country. Exchange rate is a representative of a 
currency’s price in terms of another currency. In other words, it is the price paid for buying one 
unit of foreign currency through domestic currency. There are two ways in which it can be 
expressed: 
? The units of domestic currency required to purchase one unit of foreign currency, e.g., $ 
1=Rs. 50. 
? The units of foreign currency that can be purchased in exchange for a unit of domestic 
currency, e.g., Re. 1 = 2 cents. 
In both the ways, exchange rate is a representative of purchasing muscle of domestic currency 
in form of foreign currencies. A rise in the peripheral value of the domestic currency i.e., an 
increase in exchange rate is said as an appreciation of the domestic currency. For e.g., 
suppose formerly 50 rupees were required to buy a dollar, now only 45 rupees are sufficient to 
buy a dollar. This implies that the cost of the rupee in terms of dollar has improved. As a result, 
rupee has appreciated.  A plunge in the external value of the domestic currency i.e., a fall in 
exchange rate is called a depreciation of the domestic currency. For e.g., if earlier 50 
rupees were sufficient to buy a dollar now 55 rupees are essential to buy a dollar. This implies 
that the value of the rupee in terms of dollar has lowered. Accordingly, rupee has depreciated. 
There are two types of Exchange Rates: nominal and real exchange rate. Nominal exchange 
rate defines the purchasing strength of domestic currency in terms of overseas currency. It 
reflects movement when price level changes in either of the two countries. Alternatively, Real 
exchange rate is the hypothetical exchange rate attuned for the inflation disparity between the 
two countries. For example, if A country has an inflation rate of 10%, country B has inflation 
rate of 5% and nominal rate of exchange remains unchanged, then actual price of country A 
currency is at present 10%-5%= 5% higher than before. Higher prices signify an appreciation 
of the actual exchange rate. 
4. History and Evolution of Exchange Rate 
The importance of the gold standard is highlighted in 19
th
 century. Between 1876 and 1913, the 
system of exchange rate was reliant on the individual currency’s relative convertibility to gold’s 
Exchange Rate 
Institute of Lifelong, University of Delhi 
ounce. Nevertheless, this determination method of the exchange rate had to be re-examined 
when the gold standard was poised at the time of World War I. 
The exchange rate market collapsed when the gold standard got suspended in 1914. However, 
some countries, in the early 1920s, made their effort to restore the gold standard to get the 
former exchange system back into exercise. On the other hand, United States got hit by the 
Great Depression in 1929 and most of the countries of the developed world, experienced 
destructive effects of this depression. This experience resulted in abandonment of all efforts 
made by various countries to revive gold standard. In other words, Great American depression 
of 1929 removed any hope of revival of gold standard. 
The Bretton Woods Agreement was signed by 44 countries at the time when World War II 
was about to come to an end. The platform of this article continued to be gold. As the 
shockwaves of the Great Depression were still shaking the thoughts of the makers of policies as 
they wanted to have a fool proof system so that possibilities of such disaster do not arise in 
future. The Bretton Woods Agreement found an arrangement of fixed system of exchange rates 
where the currencies of various countries were pegged to the US dollar at a fixed exchange 
rate, which is based on the gold standard.  
This new arrangement of exchange rate worked well between 1950 and 1960. Till 1971, 
countries started facing heat of fallacies of the arrangement set by the Bretton Woods 
Agreement. But by 1970, the existence of current exchange rate system had already come 
under threat. The Nixon-led US government did not allow the conversion of the national 
currency in gold as US dollar was more available than its demand. The Smithsonian Agreement 
was pinned in 1971. For the first time in the history of exchange rate system, the market 
dynamics of supply and demand started to conclude the exchange rate. 
On a very strange note, the Smithsonian Agreement could not survive for very long. 
Fluctuations started to surface in the extensively traded currencies by 1973. In a buoyant 
currency system, a currency’s value is permitted to swing in alignment with the conditions of 
the foreign exchange market. 
The floating exchange rate regime that followed the collapse of the fixed exchange rate 
system was formalized in January 1976 when IMF members met in Jamaica and agreed to the 
rules for the international monetary system that are in place today. 
Main objective of meeting at Jamaica was to relook at the articles of agreement by IMF and 
throw light at new reality of floating exchange rate.  
The benefit of a floating exchange rate system is that it is self accustomed. Greater level of 
liquidity is allowed in floating currency system and it also provides central bank control, but this 
system is vulnerable to attacks by speculators, or sudden panic-driven moves by investors that 
translates into currency crises and recessions. Since 1973, there have been various incidences 
when exchange rates have come under severe pressure mainly due to unexpected jitters in the 
world monetary system 
The present international monetary system is faced with excessive fluctuations and large 
disequilibria in exchange market. Often countries, both developed and developing, have been 
faced with either excessive appreciation or depreciation of their currencies in relation to the 
dollar which continues to dominate the world monetary system. Even the newly created Euro of 
the EU which was supposed to be a strong currency has been depreciating considerably since its 
inception against the dollar. This has adversely affected the world trade.  
5. Fixed Versus Flexible Exchange Rate 
Page 5


Exchange Rate 
Institute of Lifelong, University of Delhi 
 
 
 
 
Subject: Macroeconomics 
Lesson: Exchange Rate 
Lesson Developer: Supriti Mishra  
College/ Department: Shyam Lal College, University of Delhi 
  
Exchange Rate 
Institute of Lifelong, University of Delhi 
1.  
2. Learning outcomes 
3. Introduction  
4. Concept of exchange rate 
5. History and evolution of exchange rate 
6. Fixed versus flexible exchange rate 
6.1  Fixed Exchange Rate 
6.2 Advantages Of Fixed Exchange Rate System  
6.3 Disadvantages Of Fixed Exchange Rate System  
6.4  Flexible Exchange Rate 
6.5 Advantages of Flexible Exchange Rate System  
6.6 Disadvantages of Flexible Exchange Rate System  
7. Determinants of exchange rate 
8. Foreign exchange market 
7.1Functions of Foreign Exchange Market 
      7.2Spot and forward exchange rate 
7.3 Demand for exchange rate 
      7.4Supply of exchange rate 
7.5 Equilibrium exchange rate  
8 Changes in the exchange rate 
9 Purchasing Power Parity Theory of Exchange Rate Determination                (PPP 
THEORY) 
9.1Criticism of PPP theory 
10  Foreign exchange reserves in India 
11 Summary 
12 Exercise 
13 Glossary 
14 References  
1. Learning outcomes: 
After reading this chapter, you will be able to: 
- define the concept of exchange rate 
- describe the historical perspectives of the exchange rate 
- differentiate between fixed exchange rate and flexible exchange rate  
- know how exchange rate is determined in the free market 
Exchange Rate 
Institute of Lifelong, University of Delhi 
- describe the factors which affect the equilibrium exchange rate 
- understand how PPP theory determines the exchange rate 
2. Introduction 
In today’s time, self sufficiency of any nation does not exist and dependency on other nations 
for its internal requirement is un-deniable. A country chooses cheaper import option for 
fulfillment of internal requirement of goods and services which are not produced within the 
country. In the same manner, a country balances by exporting services and goods to other 
countries which it can supply with relative benefit. In this manner international expertise is 
achieved which is advantageous to all countries in a trade free world. In international trade, 
Problems arise as different currencies exercise exchange as a medium to use different 
currencies. This problem is primarily due to buyers and sellers belonging to multiple nations. If 
an Indian buyer is purchasing a product from a seller who is an American, then buyer is liable to 
make payment in US dollars because payment in rupees would not come under accepted norms 
of US firm. Smooth business transaction between two countries can happen through mode of 
currencies exchange. 
3. Concept of Exchange Rate 
Exchange rate is defined as the price at which one unit of currency can be exchanged for the 
number of units of currency of another country. Exchange rate is a representative of a 
currency’s price in terms of another currency. In other words, it is the price paid for buying one 
unit of foreign currency through domestic currency. There are two ways in which it can be 
expressed: 
? The units of domestic currency required to purchase one unit of foreign currency, e.g., $ 
1=Rs. 50. 
? The units of foreign currency that can be purchased in exchange for a unit of domestic 
currency, e.g., Re. 1 = 2 cents. 
In both the ways, exchange rate is a representative of purchasing muscle of domestic currency 
in form of foreign currencies. A rise in the peripheral value of the domestic currency i.e., an 
increase in exchange rate is said as an appreciation of the domestic currency. For e.g., 
suppose formerly 50 rupees were required to buy a dollar, now only 45 rupees are sufficient to 
buy a dollar. This implies that the cost of the rupee in terms of dollar has improved. As a result, 
rupee has appreciated.  A plunge in the external value of the domestic currency i.e., a fall in 
exchange rate is called a depreciation of the domestic currency. For e.g., if earlier 50 
rupees were sufficient to buy a dollar now 55 rupees are essential to buy a dollar. This implies 
that the value of the rupee in terms of dollar has lowered. Accordingly, rupee has depreciated. 
There are two types of Exchange Rates: nominal and real exchange rate. Nominal exchange 
rate defines the purchasing strength of domestic currency in terms of overseas currency. It 
reflects movement when price level changes in either of the two countries. Alternatively, Real 
exchange rate is the hypothetical exchange rate attuned for the inflation disparity between the 
two countries. For example, if A country has an inflation rate of 10%, country B has inflation 
rate of 5% and nominal rate of exchange remains unchanged, then actual price of country A 
currency is at present 10%-5%= 5% higher than before. Higher prices signify an appreciation 
of the actual exchange rate. 
4. History and Evolution of Exchange Rate 
The importance of the gold standard is highlighted in 19
th
 century. Between 1876 and 1913, the 
system of exchange rate was reliant on the individual currency’s relative convertibility to gold’s 
Exchange Rate 
Institute of Lifelong, University of Delhi 
ounce. Nevertheless, this determination method of the exchange rate had to be re-examined 
when the gold standard was poised at the time of World War I. 
The exchange rate market collapsed when the gold standard got suspended in 1914. However, 
some countries, in the early 1920s, made their effort to restore the gold standard to get the 
former exchange system back into exercise. On the other hand, United States got hit by the 
Great Depression in 1929 and most of the countries of the developed world, experienced 
destructive effects of this depression. This experience resulted in abandonment of all efforts 
made by various countries to revive gold standard. In other words, Great American depression 
of 1929 removed any hope of revival of gold standard. 
The Bretton Woods Agreement was signed by 44 countries at the time when World War II 
was about to come to an end. The platform of this article continued to be gold. As the 
shockwaves of the Great Depression were still shaking the thoughts of the makers of policies as 
they wanted to have a fool proof system so that possibilities of such disaster do not arise in 
future. The Bretton Woods Agreement found an arrangement of fixed system of exchange rates 
where the currencies of various countries were pegged to the US dollar at a fixed exchange 
rate, which is based on the gold standard.  
This new arrangement of exchange rate worked well between 1950 and 1960. Till 1971, 
countries started facing heat of fallacies of the arrangement set by the Bretton Woods 
Agreement. But by 1970, the existence of current exchange rate system had already come 
under threat. The Nixon-led US government did not allow the conversion of the national 
currency in gold as US dollar was more available than its demand. The Smithsonian Agreement 
was pinned in 1971. For the first time in the history of exchange rate system, the market 
dynamics of supply and demand started to conclude the exchange rate. 
On a very strange note, the Smithsonian Agreement could not survive for very long. 
Fluctuations started to surface in the extensively traded currencies by 1973. In a buoyant 
currency system, a currency’s value is permitted to swing in alignment with the conditions of 
the foreign exchange market. 
The floating exchange rate regime that followed the collapse of the fixed exchange rate 
system was formalized in January 1976 when IMF members met in Jamaica and agreed to the 
rules for the international monetary system that are in place today. 
Main objective of meeting at Jamaica was to relook at the articles of agreement by IMF and 
throw light at new reality of floating exchange rate.  
The benefit of a floating exchange rate system is that it is self accustomed. Greater level of 
liquidity is allowed in floating currency system and it also provides central bank control, but this 
system is vulnerable to attacks by speculators, or sudden panic-driven moves by investors that 
translates into currency crises and recessions. Since 1973, there have been various incidences 
when exchange rates have come under severe pressure mainly due to unexpected jitters in the 
world monetary system 
The present international monetary system is faced with excessive fluctuations and large 
disequilibria in exchange market. Often countries, both developed and developing, have been 
faced with either excessive appreciation or depreciation of their currencies in relation to the 
dollar which continues to dominate the world monetary system. Even the newly created Euro of 
the EU which was supposed to be a strong currency has been depreciating considerably since its 
inception against the dollar. This has adversely affected the world trade.  
5. Fixed Versus Flexible Exchange Rate 
Exchange Rate 
Institute of Lifelong, University of Delhi 
The failure of Bretton Woods System sparked a controversy whether to have fixed or a flexible 
exchange rate system in the economy.  
5.1 Fixed Exchange Rate 
One of the objectives of monetary policy of every country at all times is to have a stable 
exchange rate. The exchange rates have remained stable except during the period of the great 
depression and World War 2. Even at the Bretton Woods, linking up currencies with dollar was 
done with an objective to provide the stable exchange rates. All the leading countries tried to 
preserve the gold standard till 1930s. Establishment of international monetary fund (IMF) 
through international agreement was also having the objective of stabilizing the rate of 
exchange. Under the charter of IMF, every member country was supposed to fix the par value 
of its currency in terms of gold or dollar and maintain it.  A member country could change the 
par value of its currency i.e., devaluation or overvaluation by 10% after informing the IMF: and 
if a country had to make large variation, they would need approval from the IMF. This system of 
fixed exchange rate is known as pegged exchange rate. Under fixed exchange rate system, 
there is official intervention in the foreign exchange market to maintain a particular exchange 
rate, which may result in building up or running down the foreign exchange reserves.  
5.2 Advantages of Fixed Exchange Rate System: 
a) It eliminates the risk caused by ambiguity, and avoids violent fluctuations in the 
international trade. As a result, international trade tends to increase. 
b) It allows smooth flow of international capital as it ensures a fixed return on the foreign 
investment and it creates general confidence in foreign currencies.  
c) Speculation in exchange rate occurs only when there are fluctuations in exchange rate 
but fixed exchange rate system eliminates the possibility of speculation because here 
rates are fixed and there is no gain from speculation. 
d) It ensures economic stability of the domestic economy.  
5.3 Disadvantages of Fixed Exchange Rate System: 
a) It imposes a heavy burden on the monetary authorities for managing foreign exchange 
reserves. Countries with balance of payments deficits must have large reserves if they 
don’t want to face state of devaluation.  
b) Fixed rate of exchange is not a real exchange rate as it does not reflect the supply-
demand status of different money market.  
c) Under this system, a country mostly depends upon international institutions for 
borrowing and lending foreign currencies.  
5.4 Flexible Exchange Rate 
Flexible exchange rates are determined by market forces. The monetary authority does not 
intervene for the purpose of influencing the exchange rate. Under this regime, if there is excess 
supply of dollars in terms of rupee, the value of dollars will depreciate in terms of rupee. It will 
lead to depreciation of the exchange rate. Consequently equilibrium will be restored in the 
exchange market. On the other hand, shortage of dollars in terms of rupee will lead to 
appreciation of dollars which results in appreciation of exchange rate thereby leading to 
restoration of equilibrium in the exchange market. These market forces operate automatically 
without any intervention on the part of monetary authority.