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Theories of determination of exchange rate
The effect on monetary policy and economic variables
Monetary policy and its effects on the economy
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3.1 Determinants of Exchange Rate
Foreign exchange rate is the price of a unit of foreign currency in terms of the domestic currency . In a floating exchange rate mechanism, foreign exchange rate is determined in the same way like the price of any other commodity in a free market economy. Thus, change in the value of the domestic currency relies on factors like foreign exchange reserves, money supply in the economy, the central bank’s policies and differences in the interest yield on dated securities of the concerned economies.
The foreign exchange rate influences purchasing power of income and capital gains obtained from returns, interest rates, inflation as well as foreign direct investment through relative wage and wealth channels. This makes exchange rates an extremely important monetary tool. However, the exchange rate itself is in fact influenced by a number of factors.
3.1.1 Bank Rate
The Reserve bank of India achieves its monetary policy objectives by changing the bank rate. When such a change comes unexpected, the market changes its expectations about the future monetary policy. Therefore an increase in the bank rate, indicating a tight monetary policy, would result in expectations that the bank rate will decrease in the future. This expectation results in a depreciation of currency. However, if the market expects the bank rate to further increase to lower domestic inflation, it would result in anticipation of future appreciation of the currency. This expectation results in appreciation of the currency.
A Report of the Committee on Fuller Capital Account Convertibility accepted that volatility in exchange rate is caused due to flexible exchange rate policy, inflationary pressure and capital inflow. It recogniz...
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...porting the hypothesis. The Aloy and Gente Paper (2005) demonstrated that a country’s population structure has an impact on the overall spending, savings, affecting the purchasing power parity and thus the exchange rate.
Other principal factors that cause fluctuations in the exchange rate include the central bank’s intervention, supply of foreign exchange reserves, public debt, trading terms and political stability. Renu Kohli (2002) also attempted to check whether specific factors like structural changes in exchange rate regime, loosening of foreign exchange restrictions and trade liberalization in India had an impact on the real exchange rate. The results showed that with liberalization and development of foreign exchange markets, factors like capital flows, volatility in capital flows and forward premium have become important in determining exchange rates.
The real exchange rate tells us the rate at which we can trade the goods of one country for goods from other countries. The real exchange rate some- times referred to as the terms of trade. To view the exchange rate relationship in real terms using the nominal exchange rate, can be taken samples h a goods produced in some countries, such as cars. Suppose the price of the car with 25,000 dollars, while the price of Japanese cars is 4,000,000 yen . To compare the prices of both cars , we have to transform them into a common currency. If one dollar worth of 80 yen , the price of cars Americans to 80 x 25,000, or 2,000,000 yen. By comparing the price of an American car (2,000,000 yen) and the price of Japanese cars (4,000,000 yen), it can be concluded that the price of the American car is half the price of Japanese cars . In other words, pad a price effect we can swap two American cars to get a Japanese car . Peng count can be written as
Inflation means the increase in household spending necessary to maintain a constant standard of living. Also, Inflation in the economies of the currencies that are traded is an important factor to consider because it affects the relative value of these currencies internationally and because it can decide future policy adjustments by governments and central banks. Besides, Inflation is usually measured by governments that use groups of price levels for goods in different sectors known as price indices. These include measures such as a producer price index (PPI), which measures wholesale inflation, and a consumer price index (CPI), which measures inflation for consumers. Governments and central banks often use these indices to help decide their
So when the dollar is depreciating, the exchange rate becomes smaller. Exchange rate (foreign exchange rate, forex rate or FX rate) is the number of units of a given currency that can be purchased for one unit of another currency. The United States capital markets are becoming more attractive to foreign investors. Since the dollar is falling, it makes foreigner’s investment in the United States more affordable. Therefore, foreigners take this opportunity to invest in the United States.
Economic indicators often affect and influence the value of a country's currency. The Trade Deficit, the Gross National Product (GNP), Industrial Production, the Unemployment Rate, and Business Inventories are examples of economic indicators. We will be dealing with four specific indicators: interest rate, inflation, unemployment, and employment growth, as well as Real Gross Domestic Product (GDP). Real GDP is so called because the effects of inflation and depreciation are accounted for in the figures. The state of the economy is important both on a micro and macroeconomic level.
Open market operations directly affect the money supply through buying short-term government bonds (to expand money supply) or selling them (to contract it). Benchmark interest rates, such as the LIBOR and the Fed funds rate, affect the demand for money by raising or lowering the cost to borrow—in essence, money's price. When borrowing is cheap, firms will take on more debt to invest in hiring and expansion; consumers will make larger, long-term purchases with cheap credit; and savers will have more incentive to invest their money in stocks or other assets, rather than earn very little—and perhaps lose money in real terms—through savings accounts. Policy makers also manage risk in the banking system by mandating the reserves that banks must keep on hand. Higher reserve requirements put a damper on lending and rein in inflation.
...such methods have led not only to intervallic spikes of high inflation, disastrous devaluations and financial troubles, but also to enduringly elevated nominal and real interest rates. The possibility of devaluation precludes integration into the global financial markets. The power to devalue has not catapulted exports over the longer term. Actually, it is just the opposite. It has seen to locking developing nations into low valued-added products exposed to wide and unpredictable price shifts. The country of El Salvador calculated the pros and cons of having domestic currency through two consecutive administrations and, ultimately, made the choice to dollarize based on their critical examination. Some countries may discover it practical to conduct their own analysis, and others may find it valuable to embrace the monetary services provided by the dollar global economy.
Historically, this is outlined in the domestic societal framework (a rationalist point of view dictating political outcomes as a direct result of domestic material interests in society). Whatever society wants, society gets, leaving the consumer is to benefit from a fixed exchange rate. Competition exists between all interests. Whatever interest dominates takes the winning interest. The winning interest, then, determines the outcome. With businesses facing pressure to decrease domestic prices, consumers now have the upper hand. (Wellhausen, 10-2-14). Thus, due to the enhancing credibility of the government, consumers also are to benefit from a fixed exchange rate. (Multiple governments
In this sub-section, we present a brief overview of the Armington model that has been used by other researchers to find the relationship between exchange rate volatility and trade. In some trade models, such as neo-classical trade models, we assume that goods are homogeneous even though they are produced in different countries. Indeed, the prices of goods produced in different countries do not move in the same direction. However, it was first pointed out by Armington (1969) that goods that are produced in different countries need to be treated differently. An overview of Armington (1969) is that the change in demand for goods depends on the growth of the market in which firms compete and the growth of
Monetary policy is said to be expansionary when it increases the total supply of money in the economy more rapidly than usual. But it can also be termed as contractionary if it expands the overall money supply in a slower rate or shrink it. The price at which money can be borrowed at is usually referred to as the economy’s interest rates. The main aims of monetary policies are: control inflation, control economic growth, unemployment and the exchange rates.
The value of the US dollar relevant to other currencies is a major consideration for the Federal Reserve. If they prevent large changes in the value of the dollar, firms and individuals can comfortably plan ahead to purchase or sell goods abroad.
Economic risk is another type of exchange risks companies have to consider when dealing globally. Changes in exchange rates are bound to affect the relative prices on imports and exports, and that will again affect the competitiveness of a company. An UK exporter dealing with companies in the US would not want the US$ to depreciate, because it would make the exports more expensive for the US market, thus the company will loose business.
Floating exchange rate which is also known as fluctuating exchange rate or flexible exchange rate is an exchange rate regime where its currency is determined by foreign exchange market forces such as demand and supply of that currency relative to other currencies.
The stability of currency values plays a significant role for economic and financial stability. It is not difficult to see the exchange rate fluctuations are widely regarded as damaging. As the movements of the exchange rate have significant and large effects on the trade balance, resource allocation, domestic prices, interest rate, national income and other key economic variables. Then can exchange rate movements be predicted by these fundamental economic variables?
The foreign exchange market is one of important mechanism in the international business because foreign exchange is an intermediary for all nations in term of the growth of the economy. There are many functions of foreign exchange market in the global economy. In the international business, it uses the foreign exchange markets in four ways. First, the pay...
As the foundation for the foreign exchange process, exchange rates are one of the most important elements in business, both internationally and domestically. Defined as the rate at which one currency may be converted into another, exchange rates are used by countries in order to purchase products or services from one another. When examining these exchange rates it is important to note that their two distinct types of rates used for global trade: nominal and real.