Page 188 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance Pavitar Parkash Singh, Lovely Professional University

Notes Unit 16 : Theories of Determination of Exchange Rate
(Portfolio and Balance of Payments)

CONTENTS
Objectives
Introduction
16.1 Foreign Exchange Regimes
16.2 Volatility and Risk
16.3 Determinants of Exchange Rate
16.4 Exchange Rate Forecasting
16.5 Summary
16.6 Key-Words
16.7 Review Questions
16.8 Further Readings

Objectives

After reading this Unit students will be able to:
• Discuss the Purchasing Power Parity Theory.
• Explain the Monetary Models of Exchange Rate Determination.
Introduction

By definition, the Foreign Exchange Market is a market in which different currencies can be exchanged
at a specific rate called the foreign exchange rate. We can anticipate the huge importance of the foreign
exchange rate if we can just consider the influence of it on the imports and exports of a country.
For example, let's assume a currency appreciation - the euro against the US dollar. Firstly, the exports
of the European Union (E.U) nations will become 'expensive' for the United States of America (USA),
which among other things means that E.U product will lose in terms of competitiveness. Secondly,
such a currency appreciation will be to the benefit of E.U imports, should those be payable in US
dollars. Conversely, a depreciation3 of the euro against the US dollar will cause an opposite impact.
On the other hand, the rapid growth of international trade (both the import penetration4 and the
export ratio5) during the last decades, which was mainly due to the increase of the open economies,
enhances the significance of the foreign exchange rates.
16.1 Foreign Exchange Regimes

Undoubtedly, governments have always paid very serious attention to the exchange rate of a country's
currency, utilizing any available 'means' at hand, in order to stabilize the 'desirable' range of rate.
Historically, there were periods that governments through the central banks intervened in the foreign
exchange market in order to affect the fluctuation of the exchange rate that otherwise would be
determined by market forces. There were also periods with no intervention when the exchange rate,
just like a price (Parkin M. and King D. 1992) was determined by supply and demand.
On 22nd July, 1944, at Bretton Woods in the United States of America, 44 countries agreed that a
broad international action was necessary to maintain an international monetary system, which would
promote foreign trade6. In this respect, it established a worldwide system of fixed exchange rates
between currencies. Actually, the 'tool' was gold, with the following quota: one ounce of gold was to

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