6.2.2. Determination of the Exchange Rate

Different countries have different methods of determining their currency’s exchange rate. It can be determined through Flexible Exchange Rate, Fixed Exchange Rate or Managed Floating Exchange Rate.

There are three primary methods for determining exchange rates: flexible, fixed, and managed floating. Each method affects how a country's currency is valued in relation to others. A flexible exchange rate fluctuates based on supply and demand in the market. In contrast, a fixed exchange rate remains constant with values set by the government. Managed floating is a hybrid, where the government intervenes occasionally to stabilize currency fluctuations.

Think of a flexible exchange rate like a seesaw that moves up and down based on how heavy the weights (supply and demand) are on either side. Conversely, a fixed exchange rate is like a plank held horizontally at a fixed height above the ground, regardless of how many kids want to play on either end; it only changes if a teacher (the government) decides to raise or lower the plank.

Flexible Exchange Rate is determined by the market forces of demand and supply. It is also known as Floating Exchange Rate.

A flexible exchange rate is determined by the interaction of supply and demand in the foreign exchange market. When demand for foreign currency increases, the exchange rate rises, meaning it becomes more expensive to buy foreign currency. Market dynamics thus dictate the currency value rather than government controls.

Imagine a farmer's market where the price of apples rises whenever there are more buyers than sellers. Similarly, in the foreign exchange market, if many people want to buy dollars, the price in terms of rupees (the exchange rate) goes up, just like the price of apples does when they are in higher demand.

Suppose the demand for foreign goods and services increases (for example, due to increased international travelling by Indians), then...the demand curve shifts upward and right to the original demand curve.

When the demand for foreign goods increases, more people require foreign currency to make their purchases. This leads to an upward shift in the demand curve for that currency, causing the exchange rate to rise. Consequently, it costs more rupees to purchase the same amount of foreign currency. This phenomenon illustrates how consumer behavior impacts currency valuation.

Imagine if a new blockbuster movie is released that everyone wants to see. The cinemas are packed, and tickets are hard to get. As more people try to buy tickets, the price goes up. In foreign exchange, if many people want dollars for shopping abroad, the price of dollars also rises.

Money in any country is an asset. If Indians believe that British pound is going to increase in value relative to the rupee, they will want to hold pounds.

Speculation refers to the practice where people anticipate future changes in currency values. If investors think that a currency, like the pound, will appreciate against the rupee, they will buy pounds now to profit later. This increased demand for pounds can cause the current exchange rate to rise, effectively becoming a self-fulfilling prophecy as more people buy pounds, thus driving up its price.

It’s similar to investing in stocks. If everyone believes a particular tech stock will increase in value, more and more investors will buy it, driving the price up. Currency speculation works in much the same way.

In the short run, another factor that is important in determining exchange rate movements is the interest rate differential.

Interest rate differentials between countries can greatly affect currency values. If a country offers higher interest rates, investors will prefer to invest there, increasing demand for its currency as they need it to make investments. As demand rises, the value of that currency appreciates while the value of the investors' original currency depreciates.

Think about it like a savings account. If one bank offers a significantly higher interest rate than another, you'd want to deposit your money there. Thus, many people will exchange their current currency for the bank's currency to take advantage of the higher interest rates, driving up its value.

When income increases, consumer spending increases. Spending on imported goods is also likely to increase.

As people's incomes rise, they tend to spend more on goods, including imports. This increase in demand for foreign goods results in a higher demand for foreign currency. Consequently, this can lead to a depreciation of the domestic currency as more currency is needed to purchase the same amount of foreign goods.

Imagine a family that gets a raise. With more money available, they decide to eat out more frequently at their favorite foreign cuisine restaurant. As their demand for those foreign meals increases, they need more of foreign currency to pay their bills, which can influence the exchange rate due to the increased demand for that currency.

The purchasing Power (PPP) theory is used to make long-run predictions about exchange rates.

The Purchasing Power Parity (PPP) theory suggests that exchange rates should adjust to equalize the price levels of identical goods in different countries. Long-term changes in exchange rates often reflect differences in inflation rates between countries. If inflation rises in one country but not another, the currency of the country with higher inflation will depreciate.

Consider how prices change over time. If a hamburger costs $5 in the US and the same in India equivalent to Rs 250, the exchange rate should reflect this difference. If inflation in India grows but stays stable in the US, soon a burger in India might cost Rs 300, suggesting the rupee's value relative to the dollar should adjust accordingly.

In this exchange rate system, the Government fixes the exchange rate at a particular level.

Fixed exchange rates are set by the government and do not fluctuate based on market conditions. This can lead to stability in international transactions, but requires a government to maintain the set rate, often using its foreign reserves. If a government sets the exchange rate too high, it may need to sell foreign currency; if set too low, it may create an excess demand for foreign currency.

Imagine a price control on gas set by the government. If gas prices are kept artificially low, people will flock to buy more of it, leading to shortages—just like if a rupee is set too low against a dollar. The government must keep a close watch on the supply and demand to prevent a crisis.

--