Exchange Rate Determination

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)

Definition

Importance of BoP
The BoP is an important indicator of pressure on a countrys foreign exchange rate . The BOP helps to forecast a countrys 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 countrys goods, services, and financial assets. e.g. The demand for American goods by Indians
Rs/$

D
Q

Supply of foreign currency

Foreign Currency Supply: -derived from the foreign countrys 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/$

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/ D D1 S S1

e' 120 e 100 80 e'' S S1 D D1

Quantity DEM

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

- prices - interest rates - income levels - political factors - psychological factors - expectations

Economic policy: - monetary - fiscal

Supply of and demand for foreign exchange

Exchange rate