Question

4.Explain determination of foreign exchange rate.

Answer 1

There are two methods of foreign exchange rate determination. One method falls under the classical gold standard mechanism and another method falls under the classical pa­per currency system. Today, gold standard mechanism does not operate since no stand­ard monetary unit is now exchanged for gold.

All countries now have paper currencies not convertible to gold. Under inconvertible pa­per currency system, there are two methods of exchange rate determination. The first is known as the purchasing power parity theory and the second is known as the demand-sup­ply theory or balance of payments theory. Since today there is no believer of purchasing power parity theory, we consider only demand-supply approach to foreign exchange rate determination.

The demand for and supply of foreign exchange, currency in the economy supports to determine the foreign exchange conversion rate. The demand and supply of foreign currency in the economy is determined by prices prevailing in the domestic and foreign markets for the respective goods, commodities and services, the price elasticity of goods, and services, and also the movement of capital from one market to the another.

Additionally, to some extent, the speculative activities in the foreign exchange market, future expectations of exchange rates and so on also impact the foreign exchange currency exchange rate.

If the demand and supply of foreign currency is equal in the domestic market, then the rate of exchange would generally be in equilibrium. In economical terminology, it is described as the par-value of exchange.