THE FOREIGN EXCHANGE MARKET

• Demand for pounds would constitute a demand for foreign exchange which would be supplied in the foreign exchange market – the market in which national currencies are traded for one another.
• The major participants in this market are commercial banks, foreign exchange brokers and other authorized dealers and the monetary authorities.
• It is important to note that, although the participants themselves may have their own trading centers, the market itself is world-wide.
• There is close and continuous contact between the trading centers and the participants deal in more than one market.
• The price of one currency in terms of the other is known as the exchange rate. Since there is a symmetry between the two currencies, the exchange rate may be defined in one of the two ways.
• First, as the amount of domestic currency required to buy one unit of foreign currency and second, as the cost in foreign currency of purchasing one unit of domestic currency. 
• This is the bilateral nominal exchange rate – bilateral in the sense that they are exchange rates for one currency against another and they are nominal because they quote the exchange rate in money terms, i.e. so many rupees per dollar or per pound.
• The real exchange rate – the ratio of foreign to domestic prices, measured in the same currency.
• If the real exchange rate is equal to one, currencies are at purchasing power parity. This means that goods cost the same in two countries when measured in the same currency.
• The real exchange rate is often taken as a measure of a country’s international competitiveness. 
• Since a country interacts with many countries, we may want to see the movement of the domestic currency relative to all other currencies in a single number rather than by looking at bilateral rates. That is, we would want an index for the exchange rate against other currencies, just as we use a price index to show how the prices of goods in general have changed. This is calculated as the Nominal Effective Exchange Rate (NEER) which a multilateral rate is representing the price of a representative basket of foreign currencies, each weighted by its importance to the domestic country in international trade (the average of export and import shares is taken as an indicator of this).
• The Real Effective Exchange Rate (REER) is calculated as the weighted average of the real exchange rates of all its trade partners, the weights being the shares of the respective countries in its foreign trade.
• It is interpreted as the quantity of domestic goods required to purchase one unit of a given basket of foreign goods.

Determination of the Exchange Rate

Flexible Exchange Rates

• In a system of flexible exchange rates (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply.
• In a completely flexible system, the central banks follow a simple set of rules – they do nothing to directly affect the level of the exchange rate, in other words they do not intervene in the foreign exchange market.

Speculation:

• Exchange rates in the market depend not only on the demand and supply of exports and imports, and investment in assets, but also on foreign exchange speculation where foreign exchange is demanded for the possible gains from appreciation of the currency.

Interest Rates and the Exchange Rate:

• In the short run, another factor that is important in determining exchange rate movements is the interest rate differential i.e. the difference between interest rates between countries. 
• There are huge funds owned by banks, multinational corporations and wealthy individuals which move around the world in search of the highest interest rates.
• Thus, a rise in the interest rates at home often leads to an appreciation of the domestic currency.
• Here, the implicit assumption is that no restrictions exist in buying bonds issued by foreign governments

Income and the Exchange Rate:

• When income increases, consumer spending increases. Spending on imported goods is also likely to increase. 
• When imports increase, the demand curve for foreign exchange shifts to the right. There is a depreciation of the domestic currency.
• If there is an increase in income abroad as well, domestic exports will rise and the supply curve of foreign exchange shifts outward. On balance, the domestic currency may or may not depreciate. What happens will depend on whether exports are growing faster than imports.

Exchange Rates in the Long Run:

• The Purchasing Power Parity (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system.
• As long as there are no barriers to trade like tariffs (taxes on trade) and quotas (quantitative limits on imports), exchange rates should eventually adjust so that the same product costs the same whether measured in rupees in India, or dollars in the US, yen in Japan and so on, except for differences in transportation.
• Over the long run, therefore, exchange rates between any two national currencies adjust to reflect differences in the price levels in the two countries

Fixed Exchange Rates

• Countries have had flexible exchange rate system ever since the breakdown of the Bretton Woods system in the early 1970s.
• Prior to that, most countries had fixed or what is called pegged exchange rate system, in which the exchange rate is pegged at a particular level.
• Sometimes, a distinction is made between the fixed and pegged exchange rates.
• It is argued that while the former is fixed, the latter is maintained by the monetary authorities, in that the value at which the exchange rate is pegged (the par value) is a policy variable – it may be changed.
• There is a common element between the two systems.
• Under a fixed exchange rate system, such as the gold standard, adjustment to BoP surpluses or deficits cannot be brought about through changes in the exchange rate. 
• Adjustment must either come about „automatically‟ through the workings of the economic system (through the mechanism explained by Hume, given below) or be brought about by the government.
• A pegged exchange rate system may, as long as the exchange rate is not changed, and is not expected to change, display the same characteristics. 
• However, there is another option open to the government – it may change the exchange rate.
• A devaluation is said to occur when the exchange rate is increased by social action under a pegged exchange rate system.

Managed Floating

• Without any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system. 
• It is a mixture of a flexible exchange rate system (the float part) and a fixed rate system (the managed part).
• Under this system, also called dirty floating, central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate.
• Official reserve transactions are, therefore, not equal to zero.

THE DETERMINATION OF INCOME IN AN OPEN ECONOMY

National Income Identity for an Open Economy

• In a closed economy, there are three sources of demand for domestic goods –Consumption (C ), government spending (G), and domestic investment (I ).
• In an open economy, exports constitute an additional source of demand for domestic goods and services that comes from abroad and therefore must be added to aggregate demand. 
• Imports supplement supplies in domestic markets and constitute that part of domestic demand that falls on foreign goods and services. Therefore, the national income identity for an open economy is where, NX is net exports (exports – imports).
• A positive NX (with exports greater than imports) implies a trade surplus and a negative NX (with imports exceeding exports) implies a trade deficit. Equilibrium Output and the Trade Balance Exchange Rate Changes:
• Changes in nominal exchange rates would change the real exchange rate and hence international relative prices.
• A depreciation of the rupee will raise the cost of buying foreign goods and make domestic goods less costly.
• This will raise net exports and therefore increase aggregate demand. Conversely, a currency appreciation would reduce net exports and, therefore, decrease aggregate demand. 
• However, we must note that international trade patterns take time to respond to changes in exchange rates.
• A considerable period of time may elapse before any improvement in net exports is apparent

TRADE DEFICITS, SAVINGS AND INVESTMENT

• There is reason to worry about a country’s long-run prospects if the trade deficit reflects smaller saving or a larger budget deficit (when the economy has both trade deficit and budget deficit, it is said to be facing twin deficits).
• The deficit could reflect higher private or government consumption.
• In such cases, the country’s capital stock will not rise rapidly enough to yield enough growth (called the growth dividend) it needs to repay its debt. 
• There is less cause to worry if the trade deficit reflects a rise in investment, which will build the capital stock more quickly and increase future output. 
• However, we must note that since private saving, investment and the trade deficit are jointly determined, other factors too must be taken into account.