INTERNATIONAL FINANCE ASSIGNMENT

2018-2020

III INTERNAL

TOPIC:- EXCHANGE RATE DETERMINATION - EXPLORING THE

SUBMITTED TO:
DR. AMRITA CHAURASIA MAM

SUBMITTED BY:
VIVEK PITLIYA

MBA(FA) IV SEM

66525 “B”
Exchange Rate determination - exploring the current challenges and limitations

What is exchange rate?

It is the rate at which one currency will be exchanged for another in foreign exchange
market.

In simple term we can regard it as the value of one country’s currency in term of another
country’s currency.

We know that every country has different currencies with different values for ex:- Indian
rupees , American dollars , Chinese Yuan etc. they all have different values when we
compared them with each other and that value is called rate of exchange.

The place or platform where this exchange take place is called foreign exchange market
and the reserve of the foreign currencies with the country is called foreign exchange reserve.

When international trade take place the payment made by the importer should be in
exporter’s country’s currency , and for that the the payer have to convert local currency with
seller’s currency at available exchange rates. There are three types of exchange rates:-

Fixed rate

Floating rate

Managed rate

Determinants of exchange rates

● Simple mechanism of demand and supply

Generally we can say that exchange rates are determined by the forces of demand and
supply of the particular currency in the international market . so simply we can say that if
the demand of a particular currency rises the rates will rises & vice versa and if the supply
rises the prices declined & vice versa.

● Purchasing power parity theory (PPP theory)

This is also known as the law of one price.

It is an economic theory that estimates the amount of adjustments needed on the exchange
rate between countries in order for the exchange to be equivalent to each currency’s
purchasing power.

Determinants

● Interest rate- Whenever there is an increase in interest rates in domestic market

● Inflation rate- when inflation increases there will be less demand for local goods so it
will decreases supply of foreign currency and more demand for foreign goods which
increases demand for foreign currency.

● Government budget deficit or surplus – The market usually react negatively to

● Political conditions- internal , regional, and international political conditions and

Current challenges and limitations

Ever since the breakdown of the Bretton Woods system of fixed parities in the early 1970's,
there has been extensive interest in exploring the possibility for attaining greater steadiness
in the exchange rates of the three major currencies. In specific, since the introduction of the
euro, there has also been rehabilitated consideration to offers for the likely adoption of
exchange rate target zones. While most of us, faced with an unimpeded choice, would opt
for preparations that promise greater exchange rate constancy, I think we must also classify
that the global environment is even less friendly to such a system today than it was 25 years
ago. Realistically, there is no substitute to floating exchange rates among the three major
currencies

However, this does not mean that the major industrial countries should practice benevolent
abandonment. The undervaluation of the euro (and consistent overvaluation of the US
dollar) may have improved European exports, but it has also posed problems--not least for
developing market countries of Asia and Latin America. The good news is that a hitch has
been getting underway, thanks mainly to better economic performance in Europe and
slowing growth in the United States. It was right for the European Central Bank to make
clear that a heavily undervalued euro was improper. Its interferences have established the
ECB's institutional maturity. Markets have taken note of this. But we also know that
intervention cannot change market trends. Thus, intervention must be very discerning and,
ultimately, also well-coordinated. Although it would be unwise to enter into formal promises
about particular exchange rate levels or ranges, the IMF's largest member countries do have
a accountability to make the most of possibilities for effective policy direction to reduce
exchange rate instability and risk of misalignments.

An important supposition of research and reviews of country experience in the IMF is that no
single exchange rate regime is suitable for all members in all circumstances.

 Many developing market countries have embraced systems of managed floating. And a
number of countries still uphold fixed exchange rates. Experience has shown that heavily
managed or hanged exchange rate regimes can be tested abruptly by exchange markets,
and that it can be very costly either to defend them or to exit under disorderly circumstances.

 The necessities for a country to uphold a close or heavily achieved exchange rate are
daunting--especially when the country is strongly engaged with international capital markets.

There is basically no room for error. Countries opting for such a system must trail,
progressively, sound macroeconomic policies, and also need to be fully aware of the related
costs, including the option that extremely high interest rates might be required at times of
severe financial market burden.

Recently the international debate on the exchange rate policy options for emerging market
and developing countries has attentive on the attractiveness of "corner solutions"--either a
more cleanly floating exchange rate or a hard peg , a floating rate system is more pardoning
of policy errors, and therefore a somewhat safer solution for most countries. By this I do not
mean a system in which the authorities are uninterested to the behaviour of the exchange
rate; indeed, it may at times be suitable to adjust monetary policy in response to external
developments. But with a floating rate, there is no need to risk unmaintainable drains on its
foreign exchange reserves to defend an exchange rate target. Moreover, a country can
follow a more independent monetary policy, while receiving important signals from the
exchange markets about the soundness of its policy framework. To be sure, floating is no
solution. It requires an alternative anchor for monetary policy and inflation expectations, such
as inflation targeting. And countries can still face difficult choices--especially if they are faced
with large swings in international capital flows. Still, the absence of an exchange rate target
provides an important, extra degree of freedom for domestic policy management and dealing
with external shocks.

Global capital markets are an crucial source of financing for productive investment. But they
are also a source of volatility and risk. We should not be astonished that the recent financial
crises in emerging markets have led to renewed examination of the merits of capital
controls. 
When controls are used as a auxiliary for necessary adjustment or institutional development,
they reduce a country's growth potential, create incentives for corruption and elusion, and
impede access to foreign capital without addressing the underlying economic susceptibilities.
For this reason, even controls on short-term inflows should be used in support of sound
policies, and in combination with an exit strategy and timetable for their removal.

Reference:-

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