Determination Of The Exchange Rate

The price of one currency in terms of the other is known as the exchange rate.

The question arises as to why the foreign exchange rate (between any two currencies) is at this level and what causes its movements?

To understand the economic principles that lie behind exchange rate determination, we study the major exchange rate regimes that have characterised the international monetary system. There has been a move from a regime (an exchange rate regime or system is a set of international rules governing the setting of exchange rates) of commitment of fixed-price convertibility to one without commitments where residents enjoy greater freedom to convert domestic currency into foreign currencies but do not enjoy a price guarantee. That is,

  • Flexible Exchange Rates
  • Fixed Exchange Rates
  • Managed Floating Exchange Rates


Flexible Exchange Rates

In a system of flexible exchange rates (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply. In a completely flexible system, the central banks follow a simple set of rules – they do nothing to directly affect the level of the exchange rate, in other words they do not intervene in the foreign exchange market (and therefore, there are no official reserve transactions).

The link between the balance of payments accounts and the transactions in the foreign exchange market is evident when we recognise that all expenditures by domestic residents on foreign goods, services and assets and all foreign transfer payments (debits in the BoP accounts) also represent demand for foreign exchange.

  • The Indian resident buying a Japanese car pays for it in rupees but the Japanese exporter will expect to be paid in yen. So rupees must be exchanged for yen in the foreign exchange market.
  • Conversely, all exports by domestic residents reflect equal earnings of foreign exchange. For instance, Indian exporters will expect to be paid in rupees and, to buy our goods, foreigners must sell their currency and buy rupees.

Total credits in the BoP accounts are then equal to the supply of foreign exchange. Another reason for the demand for foreign exchange is for speculative purposes.

Let us assume, for simplicity, that India and the United States are the only countries in the world, so that there is only one exchange rate to be determined. The demand curve (DD) is downward sloping because a rise in the price of foreign exchange will increase the cost in terms of rupees of purchasing foreign goods. Imports will therefore decline and less foreign exchange will be demanded. For the supply of foreign exchange to increase as the exchange rate rises, the foreign demand for our exports must be more than unit elastic, meaning simply that a one per cent increase in the exchange rate (which results in a one per cent decline in the price of the export good to the foreign country buying our good) must result in an increase in demand of more than one per cent. If this condition is met, the rupee volume of our exports will rise more than proportionately to the rise in the exchange rate, and earnings in dollars (the supply of foreign exchange) will increase as the exchange rate rises. However, a vertical supply curve (with a unit elastic foreign demand for Indian exports) would not change the analysis. We note that here we are holding all prices other than the exchange rate constant.


In this case of flexible exchange rates without central bank intervention, the exchange rate moves to clear the market, to equate the demand for and supply of foreign exchange. In above figure, the equilibrium exchange rate is e*.

If the demand for foreign exchange goes up due to Indians travelling abroad more often, or increasingly showing a preference for imported goods, the DD curve will shift upward and rightward. The resulting intersection would be at a higher exchange rate.

Changes in the price of foreign exchange under flexible exchange Equilibrium under Flexible Exchange Rates rates are referred to as currency depreciation or appreciation.

  • In the above case, the domestic currency (rupee) has depreciated since it has become less expensive in terms of foreign currency. For instance, if the equilibrium rupee-dollar exchange rate was ₹ 45 and now it has become ₹ 50 per dollar, the rupee has depreciated against the dollar.
  • By contrast, the currency appreciates when it becomes more expensive in terms of foreign currency.

At the initial equilibrium exchange rate e*, there is now an excess demand for foreign exchange. To clear the market, the exchange rate must rise to the equilibrium value e1 as shown in below figure. The rise in exchange rate (depreciation) will cause the quantity of import demand to fall since the rupee price of imported goods rises with the exchange rate. Also, the quantity of exports demanded will increase since the rise in the exchange rate makes exports less expensive to foreigners. At the new equilibrium with e1, the supply and demand for foreign exchange is again equal.




Exchange rates in the market depend not only on the demand and supply of exports and imports, and investment in assets, but also on foreign exchange speculation where foreign exchange is demanded for the possible gains from appreciation of the currency.

Money in any country is an asset. If Indians believe that the British pound is going to increase in value relative to the rupee, they will want to hold pounds. For instance, if the current exchange rate is ₹ 80 to a pound and investors believe that the pound is going to appreciate by the end of the month and will be worth ₹ 85, investors think if they took ₹ 80,000 and bought 1,000 pounds, at the end of the month, they would be able to exchange the pounds for ₹ 85,000, thus making a profit of ₹ 5,000. This expectation would increase the demand for pounds and cause the rupee-pound exchange rate to increase in the present, making the beliefs self-fulfilling.

The above analysis assumes that interest rates, incomes and prices remain constant. However, these may change and that will shift the demand and supply curves for foreign exchange.

Interest Rates and the Exchange Rate

In the short run, another factor that is important in determining exchange rate movements is the interest rate differential i.e. the difference between interest rates between countries.

There are huge funds owned by banks, multinational corporations and wealthy individuals which move around the world in search of the highest interest rates. If we assume that government bonds in country A pay 8 per cent rate of interest whereas equally safe bonds in country B yield 10 per cent, the interest rate differential is 2 per cent. Investors from country A will be attracted by the high interest rates in country B and will buy the currency of country B selling their own currency. At the same time investors in country B will also find investing in their own country more attractive and will therefore demand less of country A’s currency. This means that the demand curve for country A’s currency will shift to the left and the supply curve will shift to the right causing a depreciation of country A’s currency and an appreciation of country B’s currency.

Thus, a rise in the interest rates at home often leads to an appreciation of the domestic currency. Here, the implicit assumption is that no restrictions exist in buying bonds issued by foreign governments.

Income and the Exchange Rate

When income increases, consumer spending increases. Spending on imported goods is also likely to increase. When imports increase, the demand curve for foreign exchange shifts to the right. There is a depreciation of the domestic currency.

If there is an increase in income abroad as well, domestic exports will rise and the supply curve of foreign exchange shifts outward. On balance, the domestic currency may or may not depreciate.

What happens will depend on whether exports are growing faster than imports.

In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world’s normally finds its currency depreciating because its imports grow faster than its exports. Its demand curve for foreign currency shifts faster than its supply curve.

Exchange Rates in the Long Run

The Purchasing Power Parity (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system.

According to the theory, as long as there are no barriers to trade like tariffs (taxes on trade) and quotas (quantitative limits on imports), exchange rates should eventually adjust so that the same product costs the same whether measured in rupees in India, or dollars in the US, yen in Japan and so on, except for differences in transportation.

Over the long run, therefore, exchange rates between any two national currencies adjust to reflect differences in the price levels in the two countries.

Example : If a shirt costs $8 in the US and ₹ 400 in India, the rupee-dollar exchange rate should be ₹ 50. To see why, at any rate higher than ₹ 50, say ₹ 60, it costs ₹ 480 per shirt in the US but only ₹ 400 in India. In that case, all foreign customers would buy shirts from India. Similarly, any exchange rate below ₹ 50 per dollar will send all the shirt business to the US. Next, we suppose that prices in India rise by 20 per cent while prices in the US rise by 50 per cent. Indian shirts would now cost ₹ 480 per shirt while American shirts cost $12 per shirt. For these two prices to be equivalent, $12 must be worth ₹ 480, or one dollar must be worth ₹ 40. The dollar, therefore, has depreciated.

According to the PPP theory, differences in the domestic inflation and foreign inflation are a major cause of adjustment in exchange rates. If one country has higher inflation than another, its exchange rate should be depreciating.

However, we note that if American prices rise faster than Indian prices and, at the same time, countries erect tariff barriers to keep Indian shirts out (but not American ones), the dollar may not depreciate. Also, there are many goods that are not tradeable and inflation rates for them will not matter. Further, few goods that different countries produce and trade are uniform or identical. Most economists contend that other factors are more important than relative prices for exchange rate determination in the short run. However, in the long run, purchasing power parity plays an important role.


Fixed Exchange Rates

Countries have had flexible exchange rate system ever since the breakdown of the Bretton Woods system in the early 1970s. Prior to that, most countries had fixed or what is called pegged exchange rate system, in which the exchange rate is pegged at a particular level.

Sometimes, a distinction is made between the fixed and pegged exchange rates. It is argued that while the former is fixed, the latter is maintained by the monetary authorities, in that the value at which the exchange rate is pegged (the par value) is a policy variable – it may be changed.

There is a common element between the two systems. Under a fixed exchange rate system, such as the gold standard, adjustment to BoP surpluses or deficits cannot be brought about through changes in the exchange rate. Adjustment must either come about ‘automatically’ through the workings of the economic system (through the mechanism explained by Hume, given below) or be brought about by the government. A pegged exchange rate system may, as long as the exchange rate is not changed, and is not expected to change, display the same characteristics. However, there is another option open to the government – it may change the exchange rate.

A devaluation is said to occur when the exchange rate is increased by social action under a pegged exchange rate system. The opposite of devaluation is a revaluation. Or, the government may choose to leave the exchange rate unchanged and deal with the BoP problem by the use of monetary and fiscal policy. Most governments change the exchange rate very infrequently.

In our analysis, we use the terms fixed and pegged exchange rates interchangeably to denote an exchange rate regime where the exchange rate is set by government decisions and maintained by government actions.

We examine the way in which a country can ‘peg’ or fix the level of its exchange rate. We assume that Reserve bank of India (RBI) wishes to fix an exact par value for the rupee at ₹ 45 per dollar (e1 in below figure). Assuming that this official exchange rate is below the equilibrium exchange rate (here e* = ₹ 50) of the flexible exchange rate system, the rupee will be overvalued and the dollar undervalued. This means that if the exchange rates were determined by market, the price of dollars in terms of rupees would have to rise to clear the market. At ₹ 45 to a dollar, the rupee is more expensive than it would be at ₹ 50 to a dollar (thinking of the rate in dollar-rupee terms, now each rupee costs 2.22 cents instead of 2 cents). At this rate, the demand for dollars is higher than the supply of dollars. Since the demand and supply schedules were constructed from the BoP accounts (measuring only autonomous transactions), this excess demand implies a deficit in the BoP. The deficit is bridged by central bank intervention. In this case, the RBI would sell dollars for rupees in the foreign exchange market to meet this excess demand AB, thus neutralising the upward pressure on the exchange rate. The RBI stands ready to buy and sell dollars at that rate to prevent the exchange rate from rising (since no one would buy at more) or falling (since no one would sell for less).


Now the RBI might decide to fix the exchange rate at a higher level – ₹ 47 per dollar – to bridge part of the deficit in BoP. This devaluation of the domestic currency would make imports expensive and our exports cheaper, leading to a narrowing of the trade deficit. It is important to note that repeated central bank intervention to finance deficits and keep the exchange rate fixed will eventually exhaust the official reserves. This is the main flaw in the system of fixed exchange rates. Once speculators believe that the exchange rate cannot be held for long they would buy foreign exchange (say, dollars) in massive amounts. The demand for dollars will rise sharply causing a BoP deficit. Without sufficient reserves, the central bank will have to allow the exchange rate to reach its equilibrium level. This might amount to an even larger devaluation than would have been required before the speculative ‘attack’ on the domestic currency began.

International experience shows that it is precisely this that has led many countries to abandon the system of fixed exchange rates. Fear of such an attack induced the US to let its currency float in 1971, one of the major events which precipitated the breakdown of the Bretton Woods system.


Managed Floating Exchange Rates

Without any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system.

It is a mixture of a flexible exchange rate system (the float part) and a fixed rate system (the managed part).

Under this system, also called dirty floating, central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate. Official reserve transactions are, therefore, not equal to zero.


Bibliography : NCERT – Introductory Macroeconomics



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