External Sector -II

Presented by-
• Aryan Bhargava
• Rakshit Baheti
Overview of the Presentation

 Brief Introduction to Foreign Exchange and Foreign Exchange Rate

 Types of Exchange Rate
 Currency Appreciation and Depreciation
 Revaluation and Devaluation
 Nominal and Real Exchange Rates
 Effects of Imports and Exports
 Theory of Purchasing Power Parity
 Case Study: Big Mac Around the World
 Questions for Review
Foreign Exchange

• Foreign exchange, or forex, is the conversion of one country's currency

into another.

• In a free economy, a country's currency is valued according to the laws

of supply and demand.

• The value of any particular currency is determined by market forces

related to trade, investment, tourism, and geopolitical risk.
Foreign Exchange Rate

• Foreign Exchange Rate, often referred to as Forex Rate or simply Exchange

Rate, is the value of one country's currency expressed in terms of another
country's currency.

• It represents the price at which one currency can be exchanged for another.

• If you can trade $1 U.S. dollar for 20 MXN (Mexican Pesos) that means you
can receive 20 MXN for each U.S. dollar. Or, for each Mexican Peso, you can
receive $. 05.
Types of Foreign Exchange Rates

Types of Foreign
Exchange Rates

Fixed Flexible Managed

Exchange Exchange Exchange
Rate Rate Rate
Fixed Exchange Rate System

• A fixed exchange rate is a system where the

value of a currency is pegged or fixed to the
value of another currency, a basket of
currencies, or a commodity like gold.

• There are two types of Exchange Rate systems:-

1) Gold Standard System

2) Britton Woods system

Gold Standard System

• The gold standard is a historical system of fixed exchange rates where

the value of a country's currency is directly linked to a specific quantity
of gold.
• Under the gold standard, currencies are freely convertible into gold at
the fixed rate. This means that individuals and other countries can
exchange their currency for gold.
• For Example:- If 1gm of Gold = Rs.1000
If 1gm of Gold = $10
From comparison, $10 = Rs.1000
Hence, $1 = Rs.100
Britton Woods System(Pegged Exchange
Rate)

• This system is also known as Pegged Exchange Rate System.

• The Bretton Woods exchange rate system was established at the
Bretton Woods Conference in 1944. It was a monetary system where
major currencies were pegged to the US dollar, and the US dollar was
pegged to gold.
• For Example:- If $1 = Rs.80
If $1 = AED 4
Hence, AED 1 = Rs.20
Flexible Exchange Rate System

• A flexible exchange rate system is a monetary arrangement

where the value of a currency is determined by the forces of
supply and demand in the foreign exchange market.
• In this system, exchange rates fluctuate freely based on
various factors such as inflation, interest rates, economic
indicators, and market speculation.
• Governments and central banks do not typically intervene to
peg or control the value of their currency, allowing it to adjust
to changing economic conditions.
• This system provides more autonomy to individual countries
in conducting monetary policy and allows for automatic
adjustments to external shocks, but it can also lead to
increased volatility in exchange rates.
Flexible Exchange Rate System
Managed Floating System

• A managed floating exchange rate system is a hybrid monetary

arrangement that combines elements of both fixed and flexible exchange
rate systems.
• In this system, the exchange rate is primarily determined by market forces
like supply and demand, similar to a flexible exchange rate system.
• Authorities such as central banks may intervene occasionally to influence
the exchange rate by buying or selling their own currency in the foreign
exchange market.
• These interventions are aimed at achieving specific policy objectives such
as stabilizing the currency, controlling inflation, or promoting exports.
• Central banks may intervene to prevent excessive volatility or to counteract
sharp movements in the exchange rate that could disrupt the economy.
Currency Appreciation

• Currency Appreciation: On the other hand, currency appreciation

happens when a currency's value increases relative to other currencies.
• It means that it takes fewer units of the appreciating currency to buy
one unit of another currency.
• Appreciation can occur due to factors like higher interest rates, strong
economic growth, political stability, or increased demand for the
currency.
• Appreciation can make imports cheaper and exports more expensive,
potentially worsening a country's trade balance.
Currency Depreciation

• Currency Depreciation: This occurs when a currency's value decreases

in relation to other currencies.
• It means that it takes more units of the depreciating currency to buy
one unit of another currency.
• Depreciation can happen due to various factors such as lower interest
rates, economic downturns, political instability, or excessive money
printing, among others.
• Depreciation can make imports more expensive and exports cheaper,
potentially improving a country's trade balance.
Revaluation of Currency

• Revaluation of Currency: Revaluation refers to the increase in the value of a

country's currency relative to other currencies in a fixed exchange rate system
or through market forces in a floating exchange rate system.

• It often occurs when a country's central bank or monetary authority decides to

adjust the exchange rate upward, typically to address economic imbalances,
control inflation, or improve the terms of trade.

• Revaluation can make imports cheaper and exports more expensive, potentially
helping to reduce trade deficits.
Devaluation of Currency

• Devaluation of Currency: Devaluation is the opposite of revaluation and refers

to the decrease in the value of a country's currency relative to other
currencies.

• It can be done deliberately by a government or central bank, or it can occur

naturally in a floating exchange rate system due to market forces.

• Devaluation is often used to boost exports by making them cheaper for foreign
buyers and to reduce trade deficits.

• However, it can also lead to higher inflation and increased costs for imports.
Difference between Depreciation and
Devaluation of Domestic Currency
Basis Depreciation of Devaluation of
Domestic Currency Domestic Currency
1.Meaning Decrease in the value of Fall in the value of
domestic currency in domestic currency by the
terms of foreign currency Govt.
by market demand and
supply.
2.Operation Takes place due to market Takes place due to the
force of demand and Govt. Order to correct
supply of foreign BOP situation
exchange.
3.System Flexible exchange rate Fixed exchange rate
system system
Difference between Appreciation and
Revaluation of Domestic Currency
Basis Appreciation of Revaluation of
Domestic Currency Domestic Currency
1.Meaning Increase in the value of Rise in the value of
domestic currency in domestic currency by the
terms of foreign currency Govt.
by market demand and
supply.
2.Operation market force of demand Takes place due to the
and supply of foreign Govt. Order to correct
exchange. BOP situation.

3.System Flexible exchange rate Fixed exchange rate

system system
Nominal Exchange Rate

• A nominal exchange rate is the price at which one currency can be

exchanged for another.

• It's the rate you see quoted in the foreign exchange market. It reflects
the relative value of one currency in terms of another, without
considering inflation or other economic factors.

• It is the value of a foreign nation's currency in terms of the home

nation's currency.
 Real Exchange Rate

The Real Exchange Rate takes into account

inflation and reflects the actual purchasing
power of one currency relative to another. It's
calculated by adjusting the nominal exchange
rate for the ratio of price levels between two
countries. In essence, it tells you how much of
one country's goods and services you can buy
with the same amount of currency from another
country, after accounting for inflation. So, unlike
the nominal exchange rate, the real exchange
rate gives a more accurate picture of the relative
value of currencies in terms of purchasing power.
Effects of Exchange Rates on Imports

• A depreciating currency makes imports more expensive for domestic

consumers, which can lead to a decrease in imports as consumers opt
for cheaper domestic alternatives.

• Conversely, an appreciating currency makes imports cheaper for

domestic consumers, potentially increasing the demand for imports.

• Exchange rate fluctuations can impact a country's trade balance by

influencing the competitiveness of its exports and the cost of its

imports.
Effects of Exchange Rates on Exports

• When a country's currency depreciates meaning its value decreases

relative to other currencies, its exports become cheaper for foreign
buyers. This can lead to an increase in exports as foreign buyers find
the goods more affordable.
• Conversely, when a country's currency appreciates (its value
increases), its exports become more expensive for foreign buyers,
potentially decreasing demand for exports.
• Exporters often closely monitor currency exchange rates and may
employ hedging strategies to manage currency risk.
The Theory of Purchasing Power Parity
(PPP)

• The Theory of Purchasing Power Parity (PPP) suggests exchange rates

should equalize prices of goods across countries.

• Overvalued currencies are expected to depreciate, undervalued to

appreciate to align with PPP rates. Short-term factors like speculation
can disrupt PPP.

• it provides insights into exchange rate determination and aids in

analyzing currency values based on purchasing power.
The Theory of Purchasing Power Parity
(PPP)
The Theory of Purchasing Power Parity
(PPP)

• Absolute PPP: According to absolute PPP, the exchange rate between

two currencies should adjust so that identical goods have the same
price when expressed in the same currency.

• For Example, if a basket of goods costs $100 in the United States and
the same basket costs €80 in the Eurozone, the exchange rate between
the dollar and the euro should be such that $100 equals €80.2.
The Theory of Purchasing Power Parity
(PPP)

Relative PPP: Relative PPP extends the

concept to include changes in price levels
over time. It suggests that the rate of
change in the exchange rate between two
currencies should be equal to the difference
in their inflation rates. In other words,
currencies with higher inflation rates should
depreciate relative to currencies with lower
inflation rates.
Case Study: The Big Mac Around the
World
• The "Big Mac Index" is a well-known concept used by economists to
assess the theory of Purchasing Power Parity (PPP). This theory
suggests that exchange rates between two currencies should adjust to
equalize the prices of a basket of goods and services across different
countries.
• The Big Mac, a standardized product sold by McDonald's in many
countries, serves as a practical example for analyzing PPP.The Big Mac
Index essentially compares the prices of a Big Mac hamburger in
various countries. According to PPP, if the theory holds true, the price
of a Big Mac should be relatively similar when converted into a
common currency (e.g., US dollars), after accounting for exchange
rates.
Case Study: The Big Mac Around the
World
• In practice, if a Big Mac costs more in one country
compared to another when converted into a common
currency, it suggests that the currency of the country with
the higher Big Mac price is overvalued relative to PPP.
• Conversely, if a Big Mac costs less when converted, it
suggests that the currency is undervalued. By analyzing
Big Mac prices and comparing them to the exchange
rates, economists can evaluate the extent to which
currencies are overvalued or undervalued relative to PPP.
• This helps in understanding whether exchange rates are
in line with what would be expected based on the relative
prices of goods and services across different countries.
Case Study: The Big Mac Around the
World
• The data collected by The Economist, as shown in the Big Mac Index
table, provides insights into how well PPP holds in practice.
• While the Big Mac Index is not a perfect measure of PPP and has its
limitations, it offers a simple and accessible way to examine currency
valuation and exchange rate dynamics in the context of purchasing
power parity.
Questions for Review

• Describe the process of currency revaluation and devaluation. When might a

country decide to revalue or devalue its currency, and what are the potential
implications for domestic and international trade?
• Discuss the role of foreign exchange markets in facilitating international trade
and investment. What are the primary participants in these markets, and how
do they influence exchange rate dynamics?
• Define nominal and real exchange rates. How are they calculated, and what
do they signify about a country's competitiveness in international markets?
Provide examples to illustrate the difference between nominal and real
exchange rates.
• India took the decision to devalue its currency in the year 1991. what were
the main factors driving the decision to devalue the rupee and also in your
opinion was this decision correct?
THANK YOU