What are exchange rates?

Submitted By Mikky

Since, the shift towards the floating exchange rate system after 1973, exchange rates have become fluid and have turned susceptible to influence from the farthest of economic factors. Many of us know what exchange rates are; simply that an American Dollar costs 12 Mexican Pesos or that a Euro costs 1.2 American Dollars. Though these numbers are being permeated since we were children, it would’ve occurred to us at least once how they are being calculated or what is that body that calculates these numbers.

What is an exchange rate ?

Exchange rates are nothing but a price, a general price which anyone pays for buying a commodity/ currency. Exchange Rates as some think are disappointingly not fixed by the governments or the Central/Federal banks. Exchange rates are not set but determined in the currency market.

The exchange rate is a computation of bartering two different currencies in relation to the general price level in the country. It can be formulated with the Absolute Purchasing Power Parity

R = P / P* where R => Exchange Rate; P => General Price Level in the domestic country; P* => General Price Level in the foreign country

If a metric ton of wheat can be bought for 300\$ in USA and INR 19000 in India then the exchange rate between these two countries is 19000/300 =INR 63. So if wheat is the only commodity in exchange between India and USA then the exchange rate between the two countries has to be 63 Indian Rupees for one US Dollar. (It is about 53 Rupees for a Dollar currently)

This is basic. That 63 Indian Rupees buys one US Dollar is rather misleading though it may sound right. What the above equation misses out is that along with goods the cash flows in and out of the country. The system that involves Trade Flows and Financial Flows no more can assist itself to determine the exchange rates on equations justifying only the Trade Flows. What triggers its ineptitude in reasoning is its mismanagement with regard to the portfolios in the Balance of Payments, specially the capital account and accountability of other exogenous factors like inflation.

Processing the same equation as above with inclusion of real world dynamics – (The Relative Purchasing Power Parity)

The equation above is more realistic. It takes into consideration the base period’s exchange rate (R0) and the current exchange rate (R1). So, if the base exchange rate (R0) was 45 Indian Rupees for a US Dollar in the base year 2000 and wheat prices were considerably less as \$280 for buying a metric ton of wheat and INR 17,000 for a metric ton of wheat in that year then the current exchange rate R1 is going to be

R1  = 46.94

By bringing in the base year the exchange rates will bring about the change in absolute purchasing power parity by adding in the externalities that are involved in the economy. This method of computation is used by the monetary authorities. The Capital account flows are well shown by adding the base year to determine the exchange which the previous model denoting absolute parity failed to determine. Though Absolute Purchasing Power Parity is the basis for the development of the modern relative concept of exchange, absolute exchange rates still remain the general notion of exchange in the currency market.

Noticing that relative exchange rates are evident through the presence of absolute exchange rates and when absolute exchange rates are absent the relative PPP concept fails to hold good. But relative model cannot be completely sidelined as this model accounts the cash flows which have been ever so critical than the goods flows through the economies after the failure of Brettonwoods System in 1973. Relative exchange rates have been more relevant post this period as the floating exchange rates system has been introduced.

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©The Idea Bucket, 2013 (Submitted by Mikky)