Determination of exchange rate, mint par theory, balance of payment theory, Purchasing power parity theory, Absolute version and relative version, Criticisms

1. Determination of
Exchange rate
SYBcom Sem IV
SDJ International College
Asst. Prof. Vaghela Nayan

2. What is Foreign Exchange?
• Foreign Exchange refers to the mechanism of the ways and means
by which payment in connection with International Trade are
effected.
• In the words of S.E. Thomas, “Foreign exchange is that branch of
the science of economics in which we seek to determine the
principles on which the people of the world settle their debts one
to another.”
• According to Heartley Withers, “Foreign exchange are a
mechanism by which international indebteness is settled between
one country and another.”

3. Meaning of Rate of Exchange
• The rate of exchange is the price of one currency expressed in
terms of another currency, it is the reflection of the external value
of the domestic currency.
• It should also be noted here that exchange rate is not always
constant, it goes on changing from time to time o account of
change in demand for and supply of foreign currency.

4. Determination of exchange Rate
• There are three important theories for the determination of
exchange rate under different monetary standards.
A. Mint Par Theory: When the two countries are on Gold Standards,
the rate of exchange is determined according to Mint Par
Theory.
B. Balance of Payment Theory: This is also known as Demand and
Supply Theory according to which the rate of exchange is
determined by the demand for and supply of foreign currency,
that is to say, the exchange rate depends on the balance of
payment situation of a country. Favourable BOP reflects strong
exchange rate and vice-versa.

5. C. Purchasing Power Parity Theory: When the two countries are on
inconvertible paper currency standard, the rate of exchange is
determined according to purchasing power parity theory.
• The basic idea underlying the PPP theory is that every unit of
currency possesses a certain degree of purchasing power, and
therefore when the domestic currency of a country is exchanged
against the foreign currency, what happen in fact is that the
domestic purchasing power is exchanged for foreign purchasing
power. So the rate of exchange is getting affected by the relative
purchasing power of the currencies of different countries.

6. • Statement of the Theory: “In the case of countries on
inconvertible paper currency standard, the basic rate of exchange
between them is determined by purchasing power – the ratio of
purchasing power of two currencies in their respective home
markets. The actual rate of exchange at any time may move away
from the purchasing power parity due to influences of demand
and supply for foreign currency, but the purchasing power par is
the point towards which the rate will constantly tend to move and
at which it must ultimately comes to rest.”

7. Two Versions of the Theory
1. Absolute version:
• This concept posits that the exchange rate between two countries will
be identical to the ratio of the price levels for those two countries. This
concept is derived from a basic idea known as the law of one price,
which states that the real price of a good must be the same across all
countries. To illustrate why this makes sense, suppose that soybeans
are currently priced at $5 a bushel in the U.S., that soybeans are priced
at 550 per bushel in India, and that the exchange rate is 50 Rs. per
dollar. Suppose that the price of soybeans goes up to 605 per bushel
(a 10% increase) in India, while the price of soybeans in the U.S. only
goes up on 5%, to $5.25 a bushel. If there is no depreciation in the
INR. to offset the 5% difference, then Indian soybeans will not be
competitive on the international market and trade flowing from
the U.S. to India will greatly increase.

8. • If we take weighted averages of prices for all goods within an
economy, absolute purchase power parity maintains that the
currency exchange rate between two countries should be identical
to the ratio of the two countries' price levels.
• This relationship can be expressed as:
• Formula
• S = P ÷ Pf
• Where S is the spot exchange rate between two countries (the rate
of the amount of foreign currency needed to trade for the
domestic currency), P is the price index for a domestic country
and Pf is the price index for a foreign country. Note that the
exchange rate used here is an indirect quote.

9. • The following conditions must be met for this relationship to be
true:
1. The goods of each country must be freely tradable on the
international market.
2. The price index for each of the two countries must be comprised
of the same basket of goods.
3. All of the prices need to be indexed to the same year.
• Even if the law of one price holds for each individual good across
countries, differences in weighting will cause absolute purchasing
power parity. Determining comparable average national price
levels is actually quite difficult and is rarely attempted. Analysts
usually examine changes in price levels (indexes), which are easier
to calculate; this gets around some of the problems of
comparability.

10. 2. Relative version:
• Under absolute version of the theory, the purchasing power of two
countries is explained with reference to only one commodity, where as
under relative version, the internal purchasing power of the two
countries is considered with reference to number of goods and services.
Thus, the theory in its relative version states that the changes in the rate
of exchange are governed by changes in the ratio of the respective
purchasing power of the two countries.
• Here, some past exchange rate is adopted at the base rate and changes
therein are measured by the ratio of price indices of respective
countries. In other words, according to the relative version of the
theory, when the price level in both the countries changes, the new
exchange rate will be the old base rate multiplied by the quotient
between the degrees of change in the purchasing power of two
countries.

11. • Symbolically it can be expressed as:
Rt = R0 x
𝑷𝒂𝒐
𝑷𝒂𝟏
x
𝑷𝒃𝟏
𝑷𝒃𝟎
Here, Rt = New exchange rate
R0 = Base rate
Pa0 = Price index of home country in base period
Pa1 = Price index of home country in current period
Pb0 = Price index of home country in base period
Pb1 = Price index of home country in current period

12. Criticisms of the Purchasing Power Parity Theory
1. It ignores many real determinants: The theory shows a direct link between the
purchasing power and exchange rate and ignores many other factors of exports and
imports involved behind the operation.
2. It is based on unrealistic assumptions: According to Heckscher, “the conception that
the exchanges represent relative price levels; or what is the same thing, that the
monetary unit of a country has the same purchasing power both within the country and
outside, it is correct only upon the never existing assumption that all goods and
services can be transferred from one country to another without cost.
3. The PPP theory is an empty truism: It states that changes in foreign exchange rate must
reflect changes in price levels of the countries. But, goods traded internally only have
no direct bearing on the exchange value of the currency and their prices may be
fluctuating without affecting the exchange rate. “Confined to internationally traded
commodities, the purchasing power parity theory becomes an empty truism,” says
Keynes.
4. The theory overlooks the influence of demand and supply factors in foreign exchange:
Nurkse underlines that the theory considers “demand simply as a function of price,
leaving out of account the wide shifts in the aggregate income and expenditure which
occur in the business cycle and which lead to wide fluctuations in the volume and
hence the value of foreign trade even if prices or price relationships remain the same.”

13. 5. The theory holds good in the long run: But, what about the short term which really is
more significant? Because, “in the long run we are all dead, and after death, there is
no economic problem.”
6. According to the theory, to calculate the new equilibrium rate, one must know the
base rate, i.e. the old equilibrium rate: But it is difficult to ascertain the particular rate
which actually prevailed among the currencies as the equilibrium rate. Moreover, the
calculated new rate would represent the equilibrium rate at purchasing power parity
only if economic conditions have remained unchanged.
7. It disregards the basis of international trade: The theory assumes that we are dealing
with a similar group of commodities in both countries. This assumption is not tenable,
when the very base of international trade is geographical specialization in production.
Moreover, the concept of a change in the price is vague in theory. Prices of all
commodities never move uniformly. Prices of some commodities rise or fall much
more than those of others. Under such conditions, no simple comparison can be
made between the price movements in different countries.

14. 8. The theory involves a practical difficulty of measuring the true purchasing power of a
currency:The theory suggests the use of price indices for measuring the changes in
purchasing power. But there are several kinds of price indices such as wholesale price index
numbers, cost of living index numbers, etc. So the question arises: which of these index
numbers should be used for calculating the changes in the purchasing power?
9. The theory neglects capital transactions in international economic relations: It fails to take
into consideration any item in the balance of payments other than merchandise trade. That is
to say, the purchasing power parity theory applies at best only to current account
transactions neglecting capital account completely. Kindleberger states that the purchasing
power parity theory is designed for trading nations and gives little guidance to a country
which is both a trader and a banker.
10. It unrealistically assumes exchange rate to be a passive variable: The theory assumes that
changes in price level could bring about changes in exchange rates and not vice versa, that
the changes in exchange rates cannot affect domestic price levels of the countries
concerned. This is not correct.
11. The theory applies to a stationary world: Changes in economic relations between two
countries are ignored by the theory. It fails to take into account that the equilibrium
exchange rate might also change following changes in economic relations between two
countries, although price levels may remain unchanged, for instance, when the flow of trade
between the original two countries will be affected, influencing the rate of exchange.

15. Thank You