A COMPREHENSIVE ANALYSIS OF FOREIGN EXCHANGE
DETERMINATION
TABLE OF CONTENTS
I. INTRODUCTION...............................................................................................................................2
II. LITERATURE REVIEW....................................................................................................................3
III. STATEMENT OF PROBLEM........................................................................................................4
IV. OBJECTIVE....................................................................................................................................4
V. HYPOTHESIS.....................................................................................................................................4
VI. RESEARCH QUESTIONS.............................................................................................................5
VII. DETERMINING THE EXCHANGE RATE...................................................................................5
VIII. DETERMINING FOREIGN EXCHANGE BY DEMAND-SUPPLY APPROACH......................6
IX. FIXED AND FLEXIBLE EXCHANGE RATES..........................................................................11
X. MANIPULATION IN EXCHANGE RATE MARKETS AND FOREIGN EXCHANGE
CONTROLS..............................................................................................................................................12
XI. CONCLUSION AND SUGGESTIONS........................................................................................13
XII. BIBLIOGRAPHY.........................................................................................................................14
1
I. INTRODUCTION
Under the field of public finance, foreign exchange is considered as a very valuable aspect. The
phenomenon of exchanging one currency with another is called foreign exchange and the rate at
which it is exchanged is called exchange rate. Foreign exchange determines the value of one
country's currency in comparison with another. For example, in order to avail 1 US dollar, 114
Japanese yen are to be paid. This is called the ratio of exchange rate Japanese yen to US dollars.
The government has the autonomy of regulating the exchange rate according to needs.1
Foreign exchange rates are determined at the market of foreign exchange, and the same is open
to several kinds of buyers and sellers and trading of currencies is a regular activity except for
weekends. The current exchange rate is also known as spot exchange rate. The forward exchange
rate means that the exchange rate that is quoted for today shall be for the delivery and payment
for a future date.2
Several money dealers tend to quote different buying and selling rates in a retail currency
exchange market. Majority of trade involves local currency. The rate of buying is the rate at
which foreign exchange currency is obtained by money dealers and the selling rate is the rate at
which the same is sold. The main determinants of profit in a foreign exchange market for a
dealer are incorporated by the margin of a dealer in trading. If the same does not happen, the
margin shall be recovered in the form of a commission or in any other possible manner. In a
foreign exchange market different rates are quoted either in cash or in electronic form. Moreover,
other important aspects related to foreign exchange are the same, security concerns, storage and
transportation costs, and the cost incurred in tying up several piles of banknotes.3
Another good example in the Indian context is that supposedly if a shawl maker, who is
Kashmiri, sells his goods to a buyer who is residing in Kanyakumari, the seller shall receive in
terms of Indian currency. The above stated fact is suggestive of the notion that the entire
domestic trade is governed by domestic currency.
1
O'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. UPPER SADDLE RIVER, NEW JERSEY
PEARSON PRENTICE HALL. p. 458 (August 31,2020, 3:42 AM), [Link]
2
The Economist, Guide to Financial Markets, THE ECONOMIST (1 September, 2020 6:44 PM),
[Link]
hl=en&pli=1.
3
Triennial Central Bank Survey, Foreign Exchange Turnover Survey of 2013: Preliminary Global Results, BANK FOR
INTERNATIONAL SETTLEMENTS(1 September, 2020 7:44 PM), [Link]
2
At the same time, if the same shawl maker decides to go abroad, we have to ensure exchange of
currency to the one of abroad (yen, dollar, euro, pound, etc.). This is when the role of banks
comes into play as the shawl maker from India will go to a bank in order to avail foreign
currencies.
The bank then codes the exchange rate of the day, i.e. the rate at which money is getting
exchanged in terms of foreign currencies. This proves how foreign exchange is necessity in order
to maintain the flow of international trade. With the help of proper regulated banking institutions
(for e.g. RBI in India), one currency is convertible to another.4
Simple mathematics to the aforementioned concept is that it is 5 UK pounds and US dollars
much rupees 400 and rupees 250 respectively then the exchange rate of pound to rupee and
dollar to rupee becomes 80 Rs.= 1 pound and Rs. 50= 1 dollar.
Depreciation in power of purchasing that is external in nature for external value of rupee (i.e.
rupee given to exchange one pound increases from 80 to 90 Rs.) would mean that the Indian
rupee is getting depreciated.
In the vice-a-versa manner if rupees given is less to that of the earlier amount, means that the
value of Indian currency is increasing and external value of pound is depreciating.5
This goes on to prove that each currency needs to have an exchange rate with another significant
currency. Not all exchangeable rates have been provided for more than 150 currencies as there is
no uniform market regarding the exchange rate system therefore Dollars and Euros are
considered as uniform rate of exchange.
II. LITERATURE REVIEW
Public Finance and International Trade by T.R. Jain and ML Grover
This book is a great and comprehensive piece of work in the field of trade and finance. The book
lays down several guiding principles regarding the intricacies of several economic theories. The
book also is a comprehensive work regarding making it clears to the researcher, the basic
intricacies of foreign exchange determination as a concept. The book has also made it clear that
4
Id.
5
Edward Sebastian, Preventing Currency Crisis in Emerging Markets, GOOGLE BOOKS, (1 September, 2020 7:44 PM),
[Link]
3
there is an analysis of several merits and demerits of foreign exchange making it a wholesome
piece of research for any scholar, academician or professor. The book also highlights the role of
government in effectively regulating the foreign exchange mechanisms.
International Economics: Trade and Finance, 11ed, ISV (WSE) by Dominick Salvatore
This book has helped the researcher in understanding various aspects of Foreign Exchange Rate
as well as its history and evolution. A contemporary analysis has been laid down in the book
regarding several advantages and disadvantages. The book has helped the researcher in
understanding the concept of Foreign Exchange Determination with special reference given to
the Balance of Payment Theory. The book also draws a picture of merits and demerits
government control in a fixed exchange rate market and a flexible exchange rate market. Lastly,
the most important features are also stated in the book for the best understanding of any scholar
or academician and the book also analyses the role of countries in Foreign Exchange
Management system.
III. STATEMENT OF PROBLEM
The researcher draws an analysis of Foreign Exchange Determination System and finds out the
merits and demerits of such a concept. The researcher has also discussed the purpose of the
concept and the theories involved in determining the Exchange Rate. The researcher in his
research has also tried to highlight a demarcation between fixed and flexible exchange rate.
IV. OBJECTIVE
The objective of this paper is to study the concept of Foreign Exchange Determination, its
features, advantages and disadvantages, purpose and manipulations involved. Also, the objective
is to do a brief study of role of government in foreign exchange management system.
V. HYPOTHESIS
The researcher is of the belief that foreign exchange has both, merits and demerits but all over is
essential for economic growth and also ensures welfare of an economy. Also, the role of
government is paramount to ensure effectively regulated foreign exchange system. Individuals
are also responsible in understanding the concept and role towards their government in the form
4
understanding the concept. Lastly, manipulation in the field of foreign exchange becomes
evident in certain situations but all over the same can be curbed by proper government control
and regulation.
VI. RESEARCH QUESTIONS
1. What is the basic concept of Foreign Exchange Rate Determination?
2. What is the role of government in Foreign Exchange?
3. What are the merits and demerits of Fixed and flexible Foreign Exchange rate?
4. What are the several theories of determining the foreign exchange?
5. How is Foreign Exchange associated with welfare of an economy?
VII. DETERMINING THE EXCHANGE RATE
After the detailed introduction two very pertinent questions lie ahead of us, first, what leads to
the determination of equilibrium exchange rate, and secondly, what are the reasons behind the
exchange rate moving up and down.
Two methods are widely accepted in the field of foreign exchange rate determination. One falls
within the category of classical gold standard mechanism while the other is an intrinsic part of
classical paper currency system. In the modern world the gold standard mechanism is not paid
enough consideration because exchange of monetary unit for gold has become an obsolete
practice today. Every country is now regulated by paper currency system not convertible to gold.
Indian convertible paper currency regimes there are two methods of exchanging foreign
currencies and determining the same. The first is known as the purchasing power parity theory
while the other is known as the demand-supply theory or the BOP theory. In the modern era
purchasing power parity theory has become an obsolete determinant and therefore only demand-
supply approach is considered in regards to foreign exchange rate.
5
VIII. DETERMINING FOREIGN EXCHANGE BY DEMAND-SUPPLY
APPROACH
Since the detrimental factor for exchange rate is associated with price, demand-supply conditions
of price theory are often used by economics. An explanation regarding the same is that the rate of
foreign exchange is equivalent to it’s apply. For better understanding we may assume that there
are two countries, India and United States of America with the Indian currency being the
domestic one.6
The US dollar is the foreign exchange while the rupee value in terms of the dollars is the foreign
exchange rate. Now, the value of one currency to the other is determined by the demand and
supply of one another in terms of foreign exchange.
Demand for Forex
When business transactions are to be executed between Indian people and US nationals in order
to settle for the payment of US goods or US gifts or purchasing of assets there, it gives rise to the
demand of foreign exchange. Foreign currency is used by several countries in order to buy its
imports. Therefore, something that appears in the debit side of BOP accounts are the sources
arising out of demand for foreign exchange. The demand for foreign exchange increases with the
increase in volume of imports.7
The foreign exchange demand curve is a negatively sloping curve. Depreciation in dollar terms
of price of rupee proof the fact that foreign goods are comparatively cheaper today. Therefore
more American goods can be bought by an Indian at a cheaper price. In a consequential manner,
increase in demand of foreign exchange i.e. dollar is regulated by increase in imports from USA.8
In a converse manner, if there is an increase in the price of dollar or the price of foreign
exchange, the foreign goods that were earlier bought at cheaper rates would now be expensive.
This will result in a fall in demand for imports and subsequently the demand for foreign
exchange also depreciates. Since price of foreign exchange and demand for foreign exchange are
6
JONGWANICH, JUTHATHIP, REAL EXCHANGE RATE OVERVALUATION AND CURRENCY CRISIS: EVIDENCE FROM THAILAND. (1st ed.,
Applied Economics), 373–382(2008).
7
Salto, Matteo; Turrini, Alessandro, Comparing alternative methodologies for real exchange rate assessment,
EUROPEAN ECONOMY - ECONOMIC PAPERS(4 September, 2020 7:36 PM),
[Link]
8
Id.
6
always in in different directions, the demand curve for importing country in terms of foreign
exchange is always sloping downwards from left to right.9
In figure 6.6, the demand curve for foreign exchange is denoted by DD1. The measuring unit in
the aforementioned figure is the exchange rate expressed in regards to the domestic currency that
is equivalent to one unit of foreign currency (i.e. dollar per rupee) on the y-axis. This is the
reason why the foreign exchange demand curve is sloping negative. If the expression of
exchange rate is done in terms of foreign currency that it has the capability of being purchased
with a unit of domestic currency (i.e. dollar per rupee), the curve of demand would denote a
slope that is positively inclined. Here the former one has been chosen by us.10
Supply of Forex
In the same manner, the supply of foreign exchange can also be determined. Supply of foreign
currency is received from its exports. If the foreign nationals and organizations have any
intention of purchasing Indian goods or assets or the same intention is towards giving grants to
the Government of India, the same leads to generation of supply of foreign exchange. This
basically means that what is exported by Indians to the entire world it is the source of foreign
9
Shruti, Foreign Exchange Rate: Meaning and its Determination, ECONOMICS DISCUSSION, (4 September, 2020 7:44
PM), [Link]
2/foreign-exchange-rate-meaning-and-its-determination/11952.
10
Id.
7
exchange. Specifically, every transaction that appears on the credit side of the BOP account leads
to generation of supply of foreign exchange.11
A substantial increase in the rupee for dollar exchange rate denotes that Indian goods are cheaper
in comparison with foreign goods in terms of dollars. Because of this India will be motivated to
export more. Foreigners will also consider investment to be more profitable in nature. Therefore
a higher price or exchange rate is detrimental of the fact that there is a substantial increase in
supply of foreign exchange. On the other hand, exchange rate falls due to low exchange rate.
This is the reason why in the aforementioned figure, SS1 is positively sloping.
Now both the demand and supply curves can be brought in consonance in order to determine
foreign exchange rate. The detrimental factor of equilibrium exchange rate is at the point where
II the demand for foreign exchange is equal to the supply of foreign exchange. DD1 and SS1
curves are intersecting at point E in figure 6.6. This means that OP is the foreign exchange rate in
the aforementioned figure.
At the same rate, demand for quantities of foreign exchange is equal to the supply of the same
(OM). This makes the market even more clear as there is no incentive left for players to change
the rate determined. It is notable that at OP demand is equivalent to supply in terms of foreign
exchange.
In regards to the aforementioned figure, is the present exchange rate OP becomes excess of the
equilibrium rate of exchange (OP), the dollar amount is increased in terms of supply by the
amount 'ab'. In regards to the financial institutions dealing with foreign exchange, the ways of
making money by exchanging currency would lessen the exchange rate to bring reduction to the
excess supply.12
This is the reason why the exchange rate continues to fall till OP. In similar manner, excess
demand for foreign exchange by the amount 'cd' is seen to rise if the rate of exchange comes
down from OP. a shortage of dollars then would be experienced by the banks in order to meet the
demand. The foreign exchange rate it will tend to rise till demand and supply becomes
equivalent.
11
Id.
12
Id.
8
The exchange rate that has been determined by us is called a floating or flexible exchange rate.
This means that the government shows minimal intervention in the forex market. A floating
exchange rate going by its definition, results in an equilibrium rate effect change which will
result in movement up and down according to change in the forces of demand and supply. The
flow of currencies is regulated by the flow in demand and supply and the same has been
illustrated in figure 6.7.13
Let us make an assumption that the national income is on a rise. The same results in demand
getting increased for import of goods and services and it further results in the rise of dollar
demand. The same is seen in the aforementioned figure as DD1 shifts to DD2. As a consequence
to the same, there is a rise in the exchange rate as the same is denoted by the intersection of the
new demand curve and supply curve. It is a notable fact that there is depreciation in rupee and
there is an appreciation in dollars.14
13
Id.
14
Id.
9
In the same manner if there is a shift in the supply curve from SS1 to SS2 as denoted in figure
6.8, OP2 shall be the new exchange rate determined further. if the national income of USA
increases because of the increase in export of Indian goods, there will be a rightward shift of the
supply curve. The consequence of the same is that there is depreciation in dollar and depreciation
in rupee. The new exchange rate is at the point of intersection of SS2 curve with the demand
curve at E2.
The above discussed topic is also known as balance of payment theory of exchange rate
determination. Wherever there is minimal intervention on the part of the government, a regulated
and flowing rate of exchange is seen to prevail. This sort of a system cannot be considered ideal
as violent exchange rate changes are visible due to frequent changes in the forces of demand and
supply. In a similar manner the trade and business system will have to face several
uncertainties.15
The free and smooth flow of trade can be damaged due to such uncertainties. Government
intervention in foreign exchange rate is becoming necessary day by day in order to prevent this
weird scenario. The same may lead to fixation of exchange rate. This exchange rate is termed as
fixed exchange rate system where manipulation for calibration of demand and supply forces by
15
Noble Drakoin, Forex for Small Speculators, GOOGLE BOOKS (4 September, 2020 7:36 PM),
[Link]
id=SJ8Q7SvWH68C&pg=PA11&dq=history+of+forex&hl=en&sa=X&ei=Wn8AUOXrFe-
T0QWR1viTBw&redir_esc=y#v=onepage&q=history%20of%20forex&f=false.
10
the financial institutions of centre and states is visible and that too in such a way that the
exchange rate is seem to be pegged at the old level.16
Several moments are suggestive of the 'managed exchange rate'. The detrimental factors in such
scenarios are the demand and supply of foreign exchange. According to the prevailing situations,
the central bank chooses to intervene or not intervene in the foreign exchange market. The
central bank shall intervene only if the market conditions require stability or influence. If there is
depreciation of a rupee in terms of dollars, the dollars would be then sold by RBI and rupees
shall be purchased in order to bring in reduction in the pressure created in exchange rate
market.17
IX. FIXED AND FLEXIBLE EXCHANGE RATES
A flexible exchange rate is the one which is regulated by government while the flexible
exchange rates are determined by market forces. The controlling of fixed exchange rate is
administered by a superlative monetary authority while the governing forces of flexible exchange
rates are the demand and supply phenomenon. While the exchange rate that is fixed involves
devaluation and evaluation of currency, a flexible exchange rate involves depreciation and
appreciation of currency. Lastly, hedging risks are there in flexible exchange rates while the
fixed exchange rate does not involve hedging risks.18
Advantages of Fixed Exchange Rates
Certainty: Trades and Investments become less risky when the parties to business
transactions are aware of the exchange rate that is fixed.
No speculations involved: there will be zero speculations from people if they are aware of
the fact that the exchange rate shall remain fixed.
Constraints shall be regulated on extreme and absurd macroeconomic government
policies.
16
THOMAS CRUMP, THE PHENOMENON OF MONEY , (1st ed., Business and Economics)(2008).
17
JOHN JAGERSON, S. WADE HANSON, ALL ABOUT FOREX TRADING (1st ed., McGraw Hill Professional)(2011).
18
Insiya, Difference Between Fixed and Flexible Exchange Rate, BANK EXAMS TODAY, (5 September, 2020 8:36 PM),
[Link]
%20exchange%20rate%20is,determined%20by%20the%20market%20force.&text=A%20fixed%20exchange
%20rate%20is%20controlled%20by%20an%20apex%20bank,the%20demand%20and%20supply%20forces..
11
Disadvantages of Fixed Exchange Rates
The economy may not be habitual of responding to shocks as the government will not
have the capacity to deal with immediate BOP crisis.
Chances of deflation of an economy are pretty evident if there is BOP crisis due to fixed
exchange rates.
Conflicts of policies are inevitable as fixed exchange rates shall not be compatible with
every economic policy that the government is ever planning to introduce.
Advantages of Flexible Exchange Rates
If the exchange rate of an economy is constantly flowing, it will lead to immunity from
sudden external shocks like oil price hikes.
The government is flexible in framing appropriate policies if there is a floating exchange
rate prevailing.
A flexible exchange rate can ensure the compensation of Balance of Payment deficit by
being accustomed to depreciation.
Disadvantages of flexible exchange rates
Large fluctuations are seen in value if there is a flexible exchange rate and the same
causes several uncertainties in firms.
A government gets arbitrary powers to frame several unsuitable domestic policies if the
exchange rate is flexible.
Several speculations can lead to several exchange rates that are completely unrelated to
the ongoing pattern of trade. This further leads to uncertainties in the firm as well.19
X. MANIPULATION IN EXCHANGE RATE MARKETS AND FOREIGN
EXCHANGE CONTROLS
Advantage in the international trade market can be gained by a country if it ensures the control
over the market for its currency to keep its value to the minimum level, typically by the central
19
Id.
12
bank of the nation indulging in operations of urban market in the market of foreign exchange.
There was a wide assertion in the early 21st century that the People's Republic of China had been
doing this for a substantial period of time.
Several countries like Japan Brazil and Iceland have ensured that there is a policy of maintaining
minimum value of their currencies. This gives this country is the hope of reducing the cost of
exports and therefore backing their respective economies. A minimal exchange rate shows a
minimal price of a country's goods in order to cater to the needs of consumers from other
geographical horizons, but raises the price of imported goods for the consumers who represent a
low value currency country. It is general notions that lower value for the currencies are expected
by exporters while higher values are preferred by importers20
The various forms of controls that the government imposes on the transaction of foreign
currencies by residents is known as foreign exchange controls. The same also extends to
transaction of local currency by non-residents and transnational currency transactions. These
controls tend to bring stability to any economy as the inflow and outflow of currency is regulated
in a day-to-day manner which may otherwise lead to volatility. In order to limit speculations
against the currencies, foreign exchange controls are generally used for developing economies or
underdeveloped countries. This ensures that there is a constant check and regulation by the
government in the foreign exchange market of a domestic country and is also very necessary in
order to stabilize the currency system and forex market of any country. A properly executed
system of foreign exchange controls leads to lessen manipulation in the exchange rate markets
and the issues that have been mentioned above in this chapter could be easily resolved if the
same is executed in a proper manner.
XI. CONCLUSION AND SUGGESTIONS
It is henceforth concluded that foreign exchange is one of the most valuable aspects in the field
of public finance. Regulation of foreign exchange rate in a proper manner is very necessary. The
role of government regulated financial institutions becomes paramount for regulating the foreign
exchange market. The balance of payment theory of determining the foreign exchange rate is the
20
EarnForex, The Use of Foreign Exchange Controls to Promote Economical Stability, EARNFOREX(5 September, 2020
8:36 PM), [Link]
13
most appropriate theory in the field as the same is still applicable in present while all other
practices have become obsolete. The problems arising with determination of foreign exchange
rate is that there is no universally accepted software or application in order to convert every
currency to every other currency. Though US dollars and pounds are the universally accepted
denominations but still in present times it would be pretty significant if a universal application is
done keeping in mind that the technology is at its apex.
XII. BIBLIOGRAPHY
1. O'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action.
UPPER SADDLE RIVER, NEW JERSEY PEARSON PRENTICE HALL. p. 458 (August 31,
2020, 3:42 AM), [Link]
2. The Economist, Guide to Financial Markets, THE ECONOMIST (1 September, 2020
6:44 PM),
[Link]
2ZmUtZGU0NzA3NGI4Y2Y5/view?hl=en&pli=1.
3. Triennial Central Bank Survey, Foreign Exchange Turnover Survey of 2013:
Preliminary Global Results, BANK FOR INTERNATIONAL SETTLEMENTS(1 September,
2020 7:44 PM), [Link]
4. Edward Sebastian, Preventing Currency Crisis in Emerging Markets, GOOGLE
BOOKS, (1 September, 2020 7:44 PM), [Link]
Q7YUOi72gC&pg=PA133&redir_esc=y#v=onepage&q&f=false.
5. JONGWANICH, JUTHATHIP, REAL EXCHANGE RATE OVERVALUATION AND
CURRENCY CRISIS: EVIDENCE FROM THAILAND. (1st ed., Applied Economics), 373–
382(2008).
6. Salto, Matteo; Turrini, Alessandro, Comparing alternative methodologies for real
exchange rate assessment, EUROPEAN ECONOMY - ECONOMIC PAPERS(4 September,
2020 7:36 PM),
[Link]
_en.pdf.
7. Shruti, Foreign Exchange Rate: Meaning and its Determination, ECONOMICS
DISCUSSION, (4 September, 2020 7:44 PM),
14
[Link]
exchange-rate-2/foreign-exchange-rate-meaning-and-its-determination/11952.
8. Noble Drakoin, Forex for Small Speculators, GOOGLE BOOKS (4 September, 2020
7:36 PM), [Link]
id=SJ8Q7SvWH68C&pg=PA11&dq=history+of+forex&hl=en&sa=X&ei=Wn8AUO
XrFe-T0QWR1viTBw&redir_esc=y#v=onepage&q=history%20of
%20forex&f=false.
9. THOMAS CRUMP, THE PHENOMENON OF MONEY, (1st ed., Business and Economics)
(2008).
10. JOHN JAGERSON, S. WADE HANSON, ALL ABOUT FOREX TRADING (1st ed.,
McGraw Hill Professional)(2011).
11. Insiya, Difference Between Fixed and Flexible Exchange Rate, BANK EXAMS TODAY,
(5 September, 2020 8:36 PM),
[Link]
[Link]#:~:text=A%20fixed%20exchange%20rate%20is,determined%20by
%20the%20market%20force.&text=A%20fixed%20exchange%20rate%20is
%20controlled%20by%20an%20apex%20bank,the%20demand%20and%20supply
%20forces..
12. EarnForex, The Use of Foreign Exchange Controls to Promote Economical Stability,
EARNFOREX(5 September, 2020 8:36 PM), [Link]
fx-controls-promote-economical-stability/#_edn2.
15