Exchange Rate Determination

Definition “The Balance Of Payments of a

country is a systematic record of all economic transactions between the ‘residents’ of a country and the rest of the world. It presents a classified record of all receipts on account of goods exported, services rendered and capital received by ‘residents’ and payments made by them on account of goods imported and services received from the capital transferred to ‘non-residents’ or ‘foreigners’.” – Reserve Bank of India (RBI)

Importance of BoP

• The BoP is an important indicator of pressure on a country’s foreign exchange rate .

• The BOP helps to forecast a country’s market potential, especially in the short run.

Contents of BoP• Current account • Capital account• Financial account• Net errors and omissions

account• Reserves and related items:

official reserve account

Current account

• Net export/import of goods (trade balance)

• Net export/import of services• Net income (investment income from

direct and portfolio investment plus employee compensation)

• Net transfers (sums sent home by migrants and permanent workers aboard, gifts, grants and pensions)

Capital account• Capital transfers related to the

purchase and sale of fixed assets such as real estate

Financial account

• Net foreign direct investment• Net portfolio investment• Other financial items

Net errors and omissions account

•Missing data such as illegal transfers

Reserves and related items: official reserve

account

• Changes in official monetary reserves including gold, foreign exchange, and IMF position.

THE DETERMINATION OF EXCHANGE RATES

• Definition: Price of a currency in terms of another currency:– direct quotation: value of a unit of

foreign currency in terms of the units of domestic currency

1 US Dollar = 45 Indian Rupees

Demand for foreign currency

Foreign Currency Demand-derived from the demand for

foreign country’s goods, services, and financial assets.

e.g. The demand for Americangoods by Indians

D

Rs/$

Q

Supply of foreign currency

Foreign Currency Supply:-derived from the foreign country’s

demand for local goods. They must convert their currency to purchase.

e.g. American demand for Indian goods means Americans convert Dollars to Indian Rupees in order to buy.

Rs/$

S

Q

Exchange Rate Equilibrium

• Forces of Demand and Supply• Demand for foreign currency negatively

related to the price of foreign currency• Supply of foreign currency positively

related to the price of foreign currency• Forces of demand and supply together

determine the exchange rate

Equilibrium Exchange Rate SIT/€

€ Quantity

€DEM

S D

S D

e 100

S1

S1

D1

D1

e'

e'' 80

120

Factors that Influence Exchange Rate Changes

• Exchange rate changes as a result of changes in the Balance-of-Payments Accounts:– systematic analysis of the influences on the

exchange rate determination and changes, caused by changes in particular types of economic transactions in the balance-of payments

– current account, capital and financial account of the balance-of-payments and international monetary reserves:• ex. relative increase in domestic prices domestic goods less

competitive increased imports & increased demand for foreign currencies

Factors that Influence Exchange Rate Changes

• Exchange rate changes as a result of changes in particular macroeconomic indicators:– Differences in the rates of inflation:

• increase in the domestic rate of the level of prices depreciation of the domestic currency

• exchange rate reflects the relative purchasing power

– Differences in the interest rates:• higher domestic interest rates appreciation of the

domestic currency

– Differences in the level of income:• higher domestic income depreciation of the domestic

currency

– Expectations– Other factors (political and psychological factors)

Schematic representation of the influence of various factors on the

market exchange rate:

Economic happenings: - change in productivity - change in wages - change in the price of electricity

Economic policy: - monetary - fiscal

- prices - interest rates - income levels

- political factors - psychological factors - expectations

Supply of and demand for foreign

exchange

Exchange

rate