EXCHANGE RATE DETERMINANTS

AND
FIXED & FLEXIBLE EXCHANGE RATES

Presented By-
Arunav Barooah(R590210006)
Harshit Mehrotra(R590210010)
Kumar Siddhartha(R590210011)
Gaurav menghi (R590210009)
Mohit Agarwal(R590210014)
Varun Kr.Dwivedi(R590210023)
1
 OUTLINE
 Exchange rate Determinants
 Fixed Exchange rate
 Flexible Exchange rate
 Conclusion

2
MEANING OF EXCHANGE RATE
 Value of one currency in units of another currency
 A decline in a currency’s value is referred to as
depreciation and an increase in currency’s value is called
appreciation.
 If currency A can buy you more units of foreign
currency, currency A has appreciated and foreign
currency depreciated
 If currency A can buy you less units of foreign currency,
currency A has depreciated and foreign currency
appreciated

3
EXCHANGE RATE DETERMINANTS
 Differentials in inflation
 Differential in interest rate
 Current account deficit
 Public debt.
 Terms of trade
 Political Stability & Economic performance

4
 DIFFERENTIALS IN INFLATION
As a general rule, a country with a consistently lower inflation
rate exhibits a rising currency value, as its purchasing power
increases relative to other currencies.

Those countries with higher inflation typically see depreciation

in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest
rates.
5
DIFFERENTIAL IN INTEREST RATE
 Interest rates, inflation and exchange rates are all highly
correlated. By manipulating interest rates, central banks
exert influence over both inflation and exchange rates,
and changing interest rates impact inflation and currency
values.
 Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore,
higher interest rates attract foreign capital and cause the
exchange rate to rise.

6
CURRENT ACCOUNT DEFICIT
 The current account is the balance of trade
between a country and its trading partners,
reflecting all payments between countries for
goods, services, interest and dividends.
 A deficit in the current account shows the
country is spending more on foreign trade
than it is earning, and that it is borrowing
capital from foreign sources to make up the
deficit.
7
 The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.

8
PUBLIC DEBT.
 Countries will engage in large-scale deficit financing to
pay for public sector projects and governmental funding.
While such activity stimulates the domestic economy,
nations with large public deficits and debts are less
attractive to foreign investors. Due to this large debt
encourages inflation, and if inflation is high, the debt
will be serviced and ultimately paid off with cheaper real
dollars in the future.

9
TERMS OF TRADE
 A ratio comparing export prices to import prices, the
terms of trade is related to current accounts and the
balance of payments. If the price of a country's exports
rises by a greater rate than that of its imports, its terms of
trade have favorably improved. Increasing terms of trade
shows greater demand for the country's exports. This, in
turn, results in rising revenue from exports, which
provides increased demand for the country's currency
(and an increasein the currency's value).

10
POLITICAL STABILITY AND ECONOMIC
PERFORMANCE
 Foreign investors inevitably seek out stable countries
with strong economic performance in which to invest
their capital. A country with such positive attributes will
draw investment funds away from other countries
perceived to have more political and economic risk.
Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to
the currencies of more stable countries

11
FIXED EXCHANGE RATE
 A fixed exchange rate, sometimes called a pegged
exchange rate, is a type of exchange rate
regime wherein a currency's value is matched to the
value of another single currency or to a basket of other
currencies, or to another measure of value, such as gold

12
 A fixed exchange rate is usually used to stabilize the
value of a currency against the currency it is pegged
to. This makes trade and investments between the
two countries easier and more predictable, and is
especially useful for small economies where external
trade forms a large part of their GDP.
 It can also be used as a means to control inflation.
However, as the reference value rises and falls, so
does the currency pegged to it., a fixed exchange
rate prevents a government from using
domestic monetary policy in order to achieve
13
macroeconomic stability.
 There are no major economic players that use a
fixed exchange rate (except the countries using
the euro and the Chinese yuan). The currencies
of the countries that now use the euro are still
existing (e.g. for old bonds). The rates of these
currencies are fixed with respect to the euro and
to each other. The most recent such country to
discontinue their fixed exchange rate was
the People's Republic of China , which did so in
July 2005
14
MAINTENANCE
 Typically, a government wanting to maintain a fixed
exchange rate does so by either buying or selling its own
currency on the open market. This is one reason
governments maintain reserves of foreign currencies. If
the exchange rate drifts too far below the desired rate,
the government buys its own currency in the market
using its reserves. This places greater demand on the
market and pushes up the price of the currency. If the
exchange rate drifts too far above the desired rate, the
government sells its own currency, thus increasing its
foreign reserves.
15
ADVANTAGES
ADVANTAGES

 Reduced risk in international trade - By maintaining a fixed

rate, buyers and sellers of goods internationally can agree a
price and not be subject to the risk of later changes in the
exchange rate before contracts are settled. The greater certainty
should help encourage investment.

 Fixed rates should eliminate destabilising speculation -

Speculation flows can be very destabilising for an economy
and the incentive to speculate is very small when the exchange
rate is fixed.
16
DISADVANTAGES
 No automatic balance of payments adjustment -With
a fixed rate, the problem would have to be solved by a
reduction in the level of aggregate demand. As demand
drops people consume less imports and also the price
level falls making you more competitive.

 Large holdings of foreign exchange reserves

required - Fixed exchange rates require a government to
hold large scale reserves of foreign currency to maintain
the fixed rate - such reserves have an opportunity cost.
17
 Fixed rates are unstable - Countries within a fixed
rate mechanism often follow different economic policies,
the result of which tends to be differing rates of inflation.
What this means is that some countries will have low
inflation and be very competitive and others will have
high inflation and not be very competitive The
uncompetitive countries will be under severe pressure
continually and may, ultimately, have to devalue.
Speculators will know this and thus creates further
pressure on that currency
18
FLEXIBLE EXCHANGE RATE
 This is the most favorable exchange rate in international market.
Followed by most of the countries.

 A currency that uses a floating exchange rate is known as a

floating currency.

 A flexible exchange rate system is a currency system that

allows the exchange rate to be determined by supply and
demand.

 In this case, the value of a currency keeps on fluctuating in

accordance with the movements of the foreign exchange market.19
 Floating exchange rate is also known to be self correcting,
because it has been seen that if there is any imbalance
between the demand and supply, the floating exchange rate
will adjust itself with the market conditions. ( e.g. if demand
for a currency is low, its value will decrease, thus making
imported goods more expensive and thus stimulating demand
for local goods and services. This in turn will generate more
jobs, and hence an auto-correction would occur in the
market.)

 Any country can not depend on any single exchange rate.

Central bank follow both kind of rates based on the
requirement.
20
BENEFIT OF FLEXIBLE EXCHANGE RATE
 Automatic balance of payments adjustment : Any balance
of payments disequilibrium will tend to be rectified by a
change in the exchange rate.

 Absence of crises - Fixed rates are often characterized by

crises as pressure mounts on a currency to devalue or
revalue. The fact that, with a floating rate, such changes are
automatic should remove the element of crisis from
international relations.

21
 Flexibility - Post-1973 there were great changes in the pattern
of world trade as well as a major change in world economics
as a result of the OPEC oil shock. A fixed exchange rate would
have caused major problems at this time as some countries
would be uncompetitive given their inflation rate. The floating
rate allows a country to re-adjust more flexibly to external
shocks.

 Lower foreign exchange reserves - A country with a fixed

rate usually has to hold large amounts of foreign currency in
order to prepare for a time when they have to defend that fixed
rate.

22
DISADVANTAGE
 Uncertainty - The fact that a currency changes in value from
day to day introduces instability or uncertainty into trade.
Sellers may be unsure of how much money they will receive
when they sell abroad.
 Speculation - Speculation will tend to be an inherent part of a
floating system and it can be damaging and destabilising for
the economy.
 Inflation - The floating exchange rate can be inflationary.
Apart from not punishing inflationary economies, which, in
itself, encourages inflation, the float can cause inflation by
allowing import prices to rise as the exchange rate falls. This
is, undoubtedly, the case for countries such as UK where we
are dependent on imports of food and raw materials. 23
FEAR OF FLOATING RATE
 A free floating exchange rate increases foreign exchange
volatility. There are economists who think that this could
cause serious problems, especially in emerging
economies.
 These economies have a financial sector with one or
more of following conditions:
 High liability dollarization

 Financial fragility

 Strong balance sheet effects

24
MAJOR CONCERN FOR FLEXIBLE RATE
 A deep and liquid foreign exchange market.

 A coherent policy governing central bank intervention in

the foreign exchange market (the practice of buying or
selling the local currency to influence its price, or
exchange rate)

 An appropriate alternative nominal anchor to replace the

fixed exchange rate.

25
 This reason emerging countries appear to face greater fear
of floating, as they have much smaller variations of the
nominal exchange rate, yet face bigger shocks and interest
rate and reserve movements.

 Affective systems for reviewing and managing the exposure

of both the public and the private sectors to exchange rate
risk.

26
Thank You

27