Exchange rate

determination
• Dr Manasi Kurtkoti
Head, department of Economics
Dr D. Y Patil ACS College, Pimpri, Pune.
Member, BOS (SPPU and MIT College)
Adjunct Professor (COEP)
 Meaning
• At the most basic level, exchange rates are
determined by demand and supply of one
currency relative to the demand and supply of
another.
• However differences in relative demand and
supply explain the determination of exchange
rates, they do it only in a superficial sense.
 Law of one price

The law of one price states that in competitive

markets free of transportation costs and barriers
to trade, identical products sold in different
countries must sell for the same price when their
price is expressed in terms of the same currency.
For example: 1£=$2
A jacket that retails for $80 in New York should
sell for £40 in London.
Purchasing power parity (PPP)-relative

PPP theory predicts that exchange rates are

determined by relative prices and that changes in
relative prices will result in a change in exchange
rates.
Interest rate parity (IRP) theory

IRP theory is a theory that suggests a

strong relationship between interest
rates and the movement of currency
values.
It suggests that future exchange rates
will be dependent upon the differences
in interest rate in two countries.
 Meaning

• International currency exchange rates display

how much one unit of a currency can be
exchanged for another currency. Currency
exchange rates can be floating, in which case
they change continually based on a multitude of
factors, or they can be pegged (or fixed) to
another currency, in which case they still float,
but they move in tandem with the currency to
which they are pegged.
 Floating vs. Fixed Exchange Rates

A floating rate is determined by the open market

through supply and demand on global currency
markets. Therefore, if the demand for the
currency is high, the value will increase. If
demand is low, this will drive that currency price
lower.
 Factors affecting exchange rate

• geopolitical and economic announcements

interest rate changes,
• unemployment rates,
• inflation reports,
• gross domestic product numbers,
• manufacturing data and commodities.
 fixed or pegged rate

• A fixed or pegged rate is determined by the

government through its central bank. The rate
is set against another major world currency
(such as the U.S. dollar, euro, or yen). To
maintain its exchange rate, the government will
buy and sell its own currency against the
currency to which it is pegged. Some countries
that choose to peg their currencies to the U.S.
dollar include China and Saudi Arabia.
Determination of exchange rate
Thank
You