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ASSIGNMENT OF INTERNATIONAL BUSINESS MANAGEMENT

Ques. - How the exchange rate between currencies is determined?Also, explains PPP theory of exchange rate?

Ans.

Exchange Rate between Currencies

Each country, through varying mechanisms, manages the value of its currency. As part of thisfunction, it determines the exchange rate regime that will apply to its currency. For example, thecurrency may be free-floating, pegged or fixed, or a hybrid.

If a currency is free-floating, its exchange rate is allowed to vary against that of other currenciesand is determined by the market forces of supply and demand. Exchange rates for suchcurrencies are likely to change almost constantly as quoted on financial markets, mainlyby banks, around the world.

A movable or adjustable peg system is a system of fixed exchange rates, but with a provision forthe devaluation of a currency. For example, between 1994 and 2005, the Chinese Yuan

renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not theonly country to do this; from the end of World until 1967, Western European countries allmaintained fixed exchange rates with the US dollar based on the Bretton Woods system. But thatsystem had to be abandoned due to market pressures and speculations in the 1970s in favor offloating, market-based regimes.

Still, some governments keep their currency within a narrow range. As a result currenciesbecome over-valued or under-valued, causing trade deficits or surpluses.

A market based exchange rate will change whenever the values of either of the two componentcurrencies change. A currency will tend to become more valuable whenever demand for it isgreater than the available supply. It will become less valuable whenever demand is less thanavailable supply (this does not mean people no longer want money, it just means they preferholding their wealth in some other form, possibly another currency).

Increased demand for a currency can be due to either an increased transaction demand formoney or an increased speculative demand for money. The transaction demand is highlycorrelated to a country's level of business activity, gross domestic product (GDP), andemployment levels. The more people that are unemployed, the less the public as a whole will

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spend on goods and services. Central banks typically have little difficulty adjusting the availablemoney supply to accommodate changes in the demand for money due to business transactions.

Speculative demand is much harder for central banks to accommodate, which they influence byadjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is

high enough. In general, the higher a country's interest rates, the greater will be the demand forthat currency. It has been argued that such speculation can undermine real economic growth, inparticular since large currency speculators may deliberately create downward pressure on acurrency by shorting in order to force that central bank to sell their currency to keep it stable.(When that happens, the speculator can buy the currency back from the bank at a lower price,close out their position, and thereby take a profit.)

The "real exchange rate" (RER) is the purchasing power of a currency relative to another. It isbased on the GDP deflator measurement of the price level in the domestic and foreign countries (

), which is arbitrarily set equal to 1 in a given base year. Therefore, the level of the RER isarbitrarily set depending on which year is chosen as the base year for the GDP deflator of twocountries. The changes of the RER are instead informative on the evolution over time of therelative price of a unit of GDP in the foreign country in terms of GDP units of the domesticcountry. If all goods were freely tradable, and foreign and domestic residents purchased identicalbaskets of goods, purchasing power parity (PPP) would hold for the GDP deflators of the twocountries, and the RER would be constant and equal to one.

Bilateral exchange rate involves a currency pair, while an effective exchange rate is a weightedaverage of a basket of foreign currencies, and it can be viewed as an overall measure of thecountry's external competitiveness. A nominal effective exchange rate (NEER) is weighted withthe inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjustsNEER by appropriate foreign price level and deflates by the home country price level. Comparedto NEER, a GDP weighted effective exchange rate might be more appropriate considering theglobal investment phenomenon.

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PURCHASE POWER PARITY THEORY

Purchasing power parity (PPP) asks how much money would be needed to purchase the same

goods and services in two different countries, and uses that to calculate an implicit foreign

exchange rate. Using that PPP rate, an amount of money thus has the same purchasing

power in different countries. Among other uses, PPP rates facilitate international comparisons

of income, as market exchange rates are often volatile, are affected by political and financial

factors that do not lead to immediate changes in income and tend to systematically understate

the standard of living in poor countries.

The PPP exchange-rate calculation is controversial because of the difficulties of findingcomparable baskets of goods to compare purchasing power across countries.

Estimation of purchasing power parity is complicated by the fact that countries do not simplydiffer in a uniform price level; rather, the difference in food prices may be greater than thedifference in housing prices, while also less than the difference in entertainment prices. People indifferent countries typically consume different baskets of goods. It is necessary to compare thecost of baskets of goods and services using a price index. This is a difficult task becausepurchasing patterns and even the goods available to purchase differ across countries. Thus, it isnecessary to make adjustments for differences in the quality of goods and services. Furthermore,the basket of goods representative of one economy will vary from that of another; Americans eatmore bread, Chinese more rice. Hence a PPP calculated using the US consumption as a base willdiffer from that calculated using China as a base. Additional statistical difficulties arise withmultilateral comparisons when (as is usually the case) more than two countries are to becompared. Various ways of averaging bilateral PPPs can provide a more stabile multilateralcomparison, but at the cost of distorting bilateral ones. These are all general issues of indexing;as with other price indices there is no way to reduce complexity to a single number that isequally satisfying for all purposes. Nevertheless, PPPs are typically robust in the face of themany problems that arise in using market exchange rates to make comparisons.

For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was $0.91 US, and inNorway the price was $6.27 US. The significant differences in price wouldn't contribute toaccuracy in a PPP analysis, despite all of the variables that contribute to the significantdifferences in price. More comparisons have to be made and used as variables in the overallformulation of the PPP.

When PPP comparisons are to be made over some interval of time, proper account needs to bemade of inflationary effects.