Introduction:

No country today is rich enough to have a free gold standard, not even
the U.S.A.
All countries have now paper currencies and these paper currencies of
the various countries are not convertible into gold or other valuable
things. Therefore, these days various countries have paper currency
standards. The exchange situation is difficult in such cases. In such
circumstances the ratio of exchange between the two currencies is
determined by their respective purchasing powers.
The purchasing power parity theory was propounded by Professor
Gustav Cassel of Sweden. According to this theory, rate of exchange
between two countries depends upon the relative purchasing power of
their respective currencies. Such will be the rate which equates the two
purchasing powers. For example, if a certain assortment of goods can be
had for £1 in Britain and a similar assortment with Rs. 80 in India, then
it is clear that the purchasing power of £ 1 in Britain is equal to the
purchasing power of Rs. 80 in India. Thus, the rate of exchange,
according to purchasing power parity theory, will be £1 = Rs. 80.
Let us take another example. Suppose in the USA one $ purchases a
given collection of commodities. In India, same collection of goods cost
60 rupees. Then rate of exchange will tend to be $ 1 = 60 rupees. Now,
suppose the price levels in the two countries remain the same but
somehow exchange rate moves to $1=61 rupees.

This means that one US$ can purchase commodities worth more than 46
rupees. It will pay people to convert dollars into rupees at this rate, ($1 =
Rs. 61), purchase the given collection of commodities in India for 60
rupees and sell them in U.S.A. for one dollar again, making a profit of 1
rupee per dollar worth of transactions.
This will create a large demand for rupees in the USA while supply
thereof will be less because very few people would export commodities
from USA to India. The value of the rupee in terms of the dollar will
move up until it will reach $1 = 60 rupees. At that point, imports from
India will not give abnormal profits. $ 1 = 60 rupees and is called the
purchasing power parity between the two countries.

Thus while the value of the unit of one currency in terms of another
currency is determined at any particular time by the market conditions of
demand and supply, in the long run the exchange rate is determined by
the relative values of the two currencies as indicated by their respective
purchasing powers over goods and services.

In other words, the rate of exchange tends to rest at the point which
expresses equality between the respective purchasing powers of the two
currencies. This point is called the purchasing power parity. Thus, under
a system of autonomous paper standards the external value of a currency
is said to depend ultimately on the domestic purchasing power of that
currency relative to that of another currency. In other words, exchange
rates, under such a system, tend to be determined by the relative
purchasing power parities of different currencies in different countries.

In the above example, if prices in India get doubled, prices in the USA
remaining the same, the value of the rupee will be exactly halved. The
new parity will be $ 1 = 120 rupees. This is because now 120 rupees will
buy the same collection of commodities in India which 60 rupees did
before. We suppose that prices in the USA remain as before. But if
prices in both countries get doubled, there will be no change in the
parity.

In actual practice, however, the parity will be modified by the cost of

transporting goods (including duties etc.) from one country to another.
Foreign Exchange Rate Determination in India and Types of
Exchange Rate
Foreign Exchange Rate Determination

Foreign Exchange Rate is the amount of domestic currency that must be

paid in order to get a unit of foreign currency. According to Purchasing
Power Parity theory, the foreign exchange rate is determined by the
relative purchasing powers of the two currencies.

Example: If a Mac Donald Burger costs $20 in the USA and Re 100 in
India, then the exchange rate between India and the USA will be
(100/20=5), 1 $ = 5 Re.

Forces Behind Exchange Rate Determination

Foreign Exchange is a price of one country currency in relation to other

country currency, which like the price of any other commodity is
determined by the demand and supply factors. The demand and supply
of the foreign exchange rate come from the residents of the respective
countries.
Demand for Foreign Exchange Supply of Foreign Exchange
(Foreign Money goes out) (Foreign Money Comes in)
Foreign Currency is needed to carry The source of foreign currency
out transactions in foreign countries available to the domestic country
or for the purchase of foreign goods are foreigners purchasing our goods
and services (IMPORTS). and services (Exports).
Foreign currency is needed to Foreigners investing in Indian
invest in foreign country Stock markets, Assets, Bonds etc.
assets/shares/bonds etc. (FPIs and FDIs)
Foreign currency is needed to make Transfer payments. Example:
transfer payments. Example: Indian Indian working in the USA, sending
Parents sending Money to his/her money to his/her old aged parents.
son/daughter studying in the USA.
Indians holding money in overseas Foreigners holding assets in Indian
Banks Banks.
Indians Travelling abroad for
Foreigners travelling to India.
Tourism Purpose.

• The DD curve represents the demand for foreign exchange by

India. The SS curve represents the supply of foreign exchange to
India.
• The point where both DD and SS curves intersect is the point of
equilibrium. At this point demand for foreign exchange is exactly
equal to the supply of foreign exchange.
• At equilibrium point E0, the exchange rate is 1 $ equal to 5 Re.
• In normal day to day functioning of markets, the exchange rate
may fluctuate. If at any point in time, the exchange rate is at E1,
 then the demand for foreign exchange falls short of supply of
foreign exchange, as a result at this point Indians are demanding
less foreign currency due to which Re will appreciate vis-à-vis
foreign currency. The appreciation mainly occurs due to a
favourable balance of payment situation (Surplus).
• By the same token at point E2, demand for foreign exchange is
greater than the supply of foreign exchange, at this point Indians
are demanding excess foreign exchange than what the foreigners
are willing to supply, as a result, at E2 Re will depreciate vis-à-vis
foreign currency. The depreciation mainly occurs due to the
unfavourable balance of payments situation(Deficits).

Types of Exchange Rate Regimes

• Fixed Exchange Rate versus Floating Exchange Rate

Fixed Exchange Rate Floating Exchange Rate
Under this system, there is Under this system, the market is
complete government intervention allowed to determine the value of
in the foreign exchange markets. exchange rate freely.
The government or central bank
determines the official exchange
The exchange rate is determined by
rate by linking exchange rate to the
the forces of demand and supply.
price of gold or major currencies
like US dollar.
If due to any reason, the exchange If due to any reason exchange rate
rate fluctuates, government fluctuates, the government never
intervenes and make sure that intervenes and allows the market to
equilibrium pre-determined level is function and determine the true
maintained. value of exchange rate.
The only merit of fixed exchange The only demerit of floating
rate system is that it assures the exchange rate system is that
stability of exchange rate. It exchange rate fluctuates a lot on
prevents both currency appreciation day to day basis.
and depreciation.

The advantages of such a system

The many disadvantages of such a are: the exchange rate is determined
system are: It puts a heavy burden in well-functioning foreign
on governments to maintain exchange markets with no
exchange rate. This especially government interference.
happens during the time of deficits,
as the governments need to infuse a The exchange rate reflects the true
lot of money to maintain exchange value of the domestic currency
rate. which helps in establishing the trust
among foreign investor.

The foreign investors avoid

investing in such countries as they A country can easily access funds/
fear to lose their investments loans from IMF and other
because they believe that exchange international institutions if the
rate does not reflect the true value exchange rate is market determined.
of the economy.

• Managed Floating Exchange rate

Manage Floating exchange rate lies in between of the two extremes of

fixed and floating exchange rate. Under such a system, the exchange is
allowed to move freely and determined by the forces of the market
(Demand and Supply). But when a difficult situation arises, the central
banks of the country can intervene to stabilise the exchange rate.
There are mainly three sub categories under managed floating exchange
rate:

1. Adjusted Peg System: In this system, a country should try to hold on

to a fixed exchange rate system for as long as it can, i.e. until the
country’s foreign exchange reserves got exhausted. Once the
country’s foreign exchange reserves got exhausted, the country
should undergo devaluation of currency and move to another
equilibrium exchange rate.
2. Crawling Peg System: In this system, a country keeps on adjusting its
exchange rate to new demand and supply conditions. The system
requires that instead of devaluing currency at the time of crisis, a
country should follow regular checks at the exchange rate and when
require must undertake small devaluations.
3. Clean Floating: In the clean float system, the exchange rate is
determined by market forces of demand and supply. The exchange
rate appreciates or depreciates as per market forces and with no
government intervention. It is identical to floating exchange rate.
4. Dirty Floating: In the dirty float system, the exchange rate is to a very
large extent is determined by the market forces of demand and supply
(so far identical to clean floating), but occasionally the central banks
of the countries intervene in foreign exchange markets to smoothen or
remove excessive fluctuations from the foreign exchange markets.
Absolute and Relative Versions of PPP:
Foreign currency is demanded by the people because it has some
purchasing power in its own nation. Also domestic currency has a
certain purchasing power, because it can buy some amount of
goods/services in the domestic economy. Thus, when home currency is
exchanged for any foreign currency, in fact the domestic purchasing is
being exchanged for the purchasing power, because it can buy some
amount of goods/ services in the domestic economy. Thus, when home
currency is exchanged for any foreign currency, in fact the domestic
purchasing power is being exchanged for the purchasing power of that
foreign currency. This exchange of the purchasing power takes place at
some specified rare where purchasing of two currencies nations gets
equalized. Thus, the relative purchasing power of the two currencies
determines the exchange rate. The exchange rate under this theory is in
equilibrium when their domestic purchasing powers at that rate of
exchanges are equivalent e.g., Suppose certain bundle of goods/ services
in U.S.A. costs U.S. $ 10 and the same bundle in India costs, Rs. 450/-
then the exchange rate between Indian Rupee and U.S. Dollar is $1 = Rs.
45. Because this is the exchange rate at which the parity between the
purchasing power of two nations is maintained. A change in the
purchasing power of any currency will reflect in the exchange rates also.
Hence under this theory the external value of the currency depends on
the domestic purchasing power of that currency relative to that of
another currency.

Gustav Cassel has presented the PPP theory in two versions.

 Absolute Version of the PPP Theory

According to the absolute version of the purchasing power parity (PPP)

theory, the exchange rates between two currencies should reflect the
relation between the international purchasng powers of various
currencies. In simple words the exchange rate would be determined, at
the point where the internal purchasing power of the respective
currencies gets equalized. Let us take an example to illustrate the point.
Suppose particular basket of goods cost Rs. 1000/- in India and $ 100 in
the U.S.A. That means the exchanges rate would be Rs. 10 = $1.

The exchange rate can be determined with the following equation.

In this equation 'P' i.e. prices are related to the respective bundle of
goods with same weights assigned in both the countries. Thus, the above
equation explains that the equilibrium exchange rate is determined by
the ratio of the internal purchasing power of foreign currency and
domestic currency in their own countries. Thus, to conclude the absolute
version of this theory maintains the the absolute version of this theory
maintains that the absolute purchasing power of respective currencies
does play a vital role in determining the equilibrium exchange rate.

Relative Version of the PPP Theory

The relative version was put forward by Cassel in order to find the
strength of the changes in the equilibrium exchange rate. Any departure
from the equilibrium will lead to the disequilibrium. It can take place
due to changes in the internal purchasing power of a particular currency.
The changes in the purchasing power are measured with the help of
domestic price indices if the respective nation. We need to assume any
past rate of exchange as a base exchange rate in order to know the
percentage change in the exchange rate. If we compare the price indices
in the past i.e. base period with that of the present period, the new
equilibrium exchange rate could be found out.

It can be simplified with the following equation.

Thus, according to the equation when the price level in concerned nation
changes, automatically the internal purchasing power of the currency of
that nation goes on changing. This change leads to the change in the
equilibrium exchange rate. Thus, under this theory Gustav Cassel has
tried to link the purchasing power of two currencies in determining the
equilibrium exchange rate. However, it has been criticized on the
following grounds.

Criticism of Purchasing Power Parity (PPP) Theory

1. Limitations of the Price Index : As seen above in the relative

version the PPP theory uses the price index in order to measure the
changes in the equilibrium rate of exchange. However, price indices
suffer from various limitations and thus theory too.
2. Neglect of the demand / supply approach : The theory fails to
explain the demand for as well as the supply of foreign exchange. The
PPP theory proves to be unsatisfactory due to this negligence.
Because in actual practice the exchange rate is determined according
to the market forces such as the demand for and supply of foreign
currency.
3. Unrealistic Approach : Since the PPP theory uses price indices
which itself proves to be unrealistic. The reason for this is that the
quality of goods and services included in the indices differs from
nation to nation. Thus, any comparison without due significance for
the quality proves to be unrealistic.
4. Unrealistic Assumptions : It is yet another valid criticism that the
PPP theory is based on the unrealistic assumptions such as absence of
 transport cost. Also it wrongly assumes that there is an absence of any
barriers to the international trade.
5. Neglects Impact of International Capital Flow : The PPP theory
neglects the impact of the international capital movements on the
foreign exchange market. International capital flows may cause
fluctuations in the existing exchange rate.
6. Rare Occurrence : According to critics, the PPP theory is in contrast
to the Practical approach. Because, the rate of exchange between any
two currencies based on the domestic price ratios is a very rare
occurrence.
Thus, the PPP theory is criticized on the above grounds.

Conclusion On Purchasing Power Parity Theory

Despite these criticisms the theory focuses on the following major

points.

1. It tries to establish relationship between domestic price level and the

exchange rates.
2. The theory explains the nature of trade as well as considers the BOP
(Balance of Payments) of a nation.

Thus, Gustav Cassell’s attempt to explain the exchange rate

determination based on domestic price indices was very unique attempt.
Exchange Rate Systems
Exchange rates are determined by demand and supply. But governments
can influence those exchange rates in various ways. The extent and
nature of government involvement in currency markets define
alternative systems of exchange rates. In this section we will examine
some common systems and explore some of their macroeconomic
implications.
There are three broad categories of exchange rate systems. In one
system, exchange rates are set purely by private market forces with no
government involvement. Values change constantly as the demand for
and supply of currencies fluctuate. In another system, currency values
are allowed to change, but governments participate in currency markets
in an effort to influence those values. Finally, governments may seek to
fix the values of their currencies, either through participation in the
market or through regulatory policy.
Free-Floating Systems
In a free-floating exchange rate system, governments and central banks
do not participate in the market for foreign exchange. The relationship
between governments and central banks on the one hand and currency
markets on the other is much the same as the typical relationship
between these institutions and stock markets. Governments may regulate
stock markets to prevent fraud, but stock values themselves are left to
float in the market. The U.S. government, for example, does not
intervene in the stock market to influence stock prices.
The concept of a completely free-floating exchange rate system is a
theoretical one. In practice, all governments or central banks intervene in
currency markets in an effort to influence exchange rates. Some
countries, such as the United States, intervene to only a small degree, so
that the notion of a free-floating exchange rate system comes close to
what actually exists in the United States.
A free-floating system has the advantage of being self-regulating. There
is no need for government intervention if the exchange rate is left to the
market. Market forces also restrain large swings in demand or supply.
Suppose, for example, that a dramatic shift in world preferences led to a
sharply increased demand for goods and services produced in Canada.
This would increase the demand for Canadian dollars, raise Canada’s
exchange rate, and make Canadian goods and services more expensive
for foreigners to buy. Some of the impact of the swing in foreign
demand would thus be absorbed in a rising exchange rate. In effect, a
free-floating exchange rate acts as a buffer to insulate an economy from
the impact of international events.
The primary difficulty with free-floating exchange rates lies in their
unpredictability. Contracts between buyers and sellers in different
countries must not only reckon with possible changes in prices and other
factors during the lives of those contracts, they must also consider the
possibility of exchange rate changes. An agreement by a U.S. distributor
to purchase a certain quantity of Canadian lumber each year, for
example, will be affected by the possibility that the exchange rate
between the Canadian dollar and the U.S. dollar will change while the
contract is in effect. Fluctuating exchange rates make international
transactions riskier and thus increase the cost of doing business with
other countries.
Managed Float Systems
Governments and central banks often seek to increase or decrease their
exchange rates by buying or selling their own currencies. Exchange rates
are still free to float, but governments try to influence their values.
Government or central bank participation in a floating exchange rate
system is called a managed float.
Countries that have a floating exchange rate system intervene from time
to time in the currency market in an effort to raise or lower the price of
their own currency. Typically, the purpose of such intervention is to
prevent sudden large swings in the value of a nation’s currency. Such
intervention is likely to have only a small impact, if any, on exchange
rates. Roughly $1.5 trillion worth of currencies changes hands every day
in the world market; it is difficult for any one agency—even an agency
the size of the U.S. government or the Fed—to force significant changes
in exchange rates.
Still, governments or central banks can sometimes influence their
exchange rates. Suppose the price of a country’s currency is rising very
rapidly. The country’s government or central bank might seek to hold
off further increases in order to prevent a major reduction in net exports.
An announcement that a further increase in its exchange rate is
unacceptable, followed by sales of that country’s currency by the central
bank in order to bring its exchange rate down, can sometimes convince
other participants in the currency market that the exchange rate will not
rise further. That change in expectations could reduce demand for and
increase supply of the currency, thus achieving the goal of holding the
exchange rate down.
Fixed Exchange Rates
In a fixed exchange rate system, the exchange rate between two
currencies is set by government policy. There are several mechanisms
through which fixed exchange rates may be maintained. Whatever the
system for maintaining these rates, however, all fixed exchange rate
systems share some important features.
A Commodity Standard
In a commodity standard system, countries fix the value of their
respective currencies relative to a certain commodity or group of
commodities. With each currency’s value fixed in terms of the
commodity, currencies are fixed relative to one another.
For centuries, the values of many currencies were fixed relative to gold.
Suppose, for example, that the price of gold were fixed at $20 per ounce
in the United States. This would mean that the government of the United
States was committed to exchanging 1 ounce of gold to anyone who
handed over $20. (That was the case in the United States—and $20 was
roughly the price—up to 1933.) Now suppose that the exchange rate
between the British pound and gold was £5 per ounce of gold. With £5
and $20 both trading for 1 ounce of gold, £1 would exchange for $4. No
one would pay more than $4 for £1, because $4 could always be
exchanged for 1/5 ounce of gold, and that gold could be exchanged for
£1. And no one would sell £1 for less than $4, because the owner of £1
could always exchange it for 1/5 ounce of gold, which could be
exchanged for $4. In practice, actual currency values could vary slightly
from the levels implied by their commodity values because of the costs
involved in exchanging currencies for gold, but these variations are
slight.
Under the gold standard, the quantity of money was regulated by the
quantity of gold in a country. If, for example, the United States
guaranteed to exchange dollars for gold at the rate of $20 per ounce, it
could not issue more money than it could back up with the gold it
owned.
The gold standard was a self-regulating system. Suppose that at the fixed
exchange rate implied by the gold standard, the supply of a country’s
currency exceeded the demand. That would imply that spending flowing
out of the country exceeded spending flowing in. As residents supplied
their currency to make foreign purchases, foreigners acquiring that
currency could redeem it for gold, since countries guaranteed to
exchange gold for their currencies at a fixed rate. Gold would thus flow
out of the country running a deficit. Given an obligation to exchange the
country’s currency for gold, a reduction in a country’s gold holdings
would force it to reduce its money supply. That would reduce aggregate
demand in the country, lowering income and the price level. But both of
those events would increase net exports in the country, eliminating the
deficit in the balance of payments. Balance would be achieved, but at the
cost of a recession. A country with a surplus in its balance of payments
would experience an inflow of gold. That would boost its money supply
and increase aggregate demand. That, in turn, would generate higher
prices and higher real GDP. Those events would reduce net exports and
correct the surplus in the balance of payments, but again at the cost of
changes in the domestic economy.
Because of this tendency for imbalances in a country’s balance of
payments to be corrected only through changes in the entire economy,
nations began abandoning the gold standard in the 1930s. That was the
period of the Great Depression, during which world trade virtually was
ground to a halt. World War II made the shipment of goods an extremely
risky proposition, so trade remained minimal during the war. As the war
was coming to an end, representatives of the United States and its allies
met in 1944 at Bretton Woods, New Hampshire, to fashion a new
mechanism through which international trade could be financed after the
war. The system was to be one of fixed exchange rates, but with much
less emphasis on gold as a backing for the system.
In recent years, a number of countries have set up currency board
arrangements, which are a kind of commodity standard, fixed exchange
rate system in which there is explicit legislative commitment to
exchange domestic currency for a specified foreign currency at a fixed
rate and a currency board to ensure fulfillment of the legal obligations
this arrangement entails. In its simplest form, this type of arrangement
implies that domestic currency can be issued only when the currency
board has an equivalent amount of the foreign currency to which the
domestic currency is pegged. With a currency board arrangement, the
country’s ability to conduct independent monetary policy is severely
limited. It can create reserves only when the currency board has an
excess of foreign currency. If the currency board is short of foreign
currency, it must cut back on reserves.
Argentina established a currency board in 1991 and fixed its currency to
the U.S. dollar. For an economy plagued in the 1980s with falling real
GDP and rising inflation, the currency board served to restore
confidence in the government’s commitment to stabilization policies and
to a restoration of economic growth. The currency board seemed to work
well for Argentina for most of the 1990s, as inflation subsided and
growth of real GDP picked up.
The drawbacks of a currency board are essentially the same as those
associated with the gold standard. Faced with a decrease in
consumption, investment, and net exports in 1999, Argentina could not
use monetary and fiscal policies to try to shift its aggregate demand
curve to the right. It abandoned the system in 2002.