Determination of Exchange Rate

"Determination of Exchange Rate"
Determination of Exchange Rate

Definition of Exchange Rate

Exchange rate is the value of one currency for the purpose of conversion to another.

In other words exchange rate is the value of one currency in units of another currency.

Example: The exchange rate of the dollar against the Taka.

Measuring Exchange Rate Movements

  • An exchange rate measures the value of one currency in units of another currency.
  • When a currency declines in value, it is said to depreciate. When it increases in value, it is said to appreciate.
  • On the days when some currencies appreciate while others depreciate against the dollar, the dollar is said to be “mixed in trading.”
  • A positive % represents appreciation of the foreign currency, while a negative % represents depreciation.

Methods of Exchange Rates Determination

Non-intervention: Currency in a floating rate world.

Example: Positive non-intervention was the economic policy of Hong Kong; this policy can be traced back to the time when Hong Kong was under British rule. It was first officially implemented in 1971 by John Cowperthwaite, who observed that the economy was doing well in the absence of government intervention but it was important to create the regulatory and physical infrastructure to facilitate market-based decision making.

Intervention: Currency in managed floating rate world.

In other words a monetary policy tool in which a central bank takes an active participatory role in influencing the monetary funds transfer rate of the national currency. Central banks, especially those in developing countries, intervene in the foreign exchange market in order to build reserves, stabilize the exchange rate and to correct misalignment.

There has two types of intervention:

1. Direct Intervention: Government directly handle the rate. As an example govt. fixed the $ price for Tk. 77.20 for tomorrow.

2. Indirect Intervention: In that case govt. has some indirect tools to control the factors by using these tools.

It is also the indirect instruments of monetary policy with some capital controls.

As an example, taxes or restrictions on international transactions in assets and the restriction of trade in currencies etc.

Exchange Rate Equilibrium

An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.

In other ways, Exchange Rate Equilibrium is the exchange rate at which the supply for a currency meets the demand of the same currency. Hence equilibrium is achieved when a currency’s demand is equal to its supply.

Factors that Influence Exchange Rates

Relative Inflation Rates:

Relative inflation rates is the comparative inflation rate between two countries.

Example: Bangladesh Inflation Rate is 8%; where India inflation rate is 10%. So the relative inflation rate is (10-8 = 2) 2%.

Impact of Relative Inflation Rates:

From the above example we can say that, the Indian people will go to buy products from Bangladesh because of low price of the goods for the reason of that low inflation rate than India.

Relative Interest Rates:

Relative interest rate is the comparative interest rate between two countries.

In other ways, Relative interest rates compare rates between one interest-bearing security, and a benchmark risk-free interest rate, such as Bangladesh Treasuries.

For example, a 30-year mortgage may carry a 9 percent interest rate, while 30-year treasury bonds pay 5 percent interest rates. The mortgage’s relative interest rate is 4 percent.

Relative Income Level:

Relative income level is the comparative income level between two countries.

In other ways, Relative income level measures your income in relation to other members of society, weighing it against the standards of the day.

Example: If Bangladesh income level is high and has no change in Indian income level. In that Bangladeshi people will get the interest to buy Indian products because of low price comparatively Bangladesh. For the reason of that if income level is high than the product price will be high.


  • Foreign exchange markets react to any news that may have a future effect.
  • Institutional investors often take currency positions based on anticipated interest rate movements in various countries.
  • Because of speculative transactions, foreign exchange rates can be very volatile.

Government Controls:

Governments may influence the equilibrium exchange rate by:

  • imposing foreign exchange barriers,
  • imposing foreign trade barriers,
  • intervening in the foreign exchange market, and
  • affecting macro variables such as inflation, interest rates, and income levels.

How Central Bank Intervene?

Depending on the Market Conditions, a central bank may do any of the following:

  • Coordinate its action with other central banks or go it alone.
  • Enter the market aggressively to change attitudes about its views and policies.
  • Intervene to reverse, resist or support a market trend.
  • Announce or not announce its operations be very visible or very discreet.
  • Operate openly or indirectly through brokers.

Currency Convertibility

Currency Convertibility is the ease with which a country’s currency can be converted into another currency or gold. Convertibility is exceedingly significant for international business. When one currency in in-convertible, it creates danger and obstacle to do business with foreigners who have no require for the domestic currency.

Hard Currencies

It is stable, convertible currency (such as the Euro, US dollar, or Yen) or that take pleasure in the self-assurance of investors and traders in a similar way.
In other ways it is a currency that is not to be expected to depreciate out of the blue regarding the value.
Example: Germany once had a solid economy, good fiscal and monetary policies, and a hard currency.

Soft Currencies

Soft currency is a currency which is hectic sensitive and fluctuates repeatedly. Such types of currencies act in response very piercingly to the political or the economic circumstances of a country.
In other ways, currency being in the right place to a small, weak, or passionately fluctuating economy and which, therefore, is not in good turn with foreign exchange traders.
Example: Zimbabwean dollar is a typical instance of soft currency. And Russia’s ruble, are permanent at impractical exchange rates and are not backed by gold.

Controlling Convertibility

Controlling Convertibility is the feature that permits money or other financial instruments to be converted into other liquid stores of value under state control and became a monopoly concession of the central banks.


License is permission from an authority to own or use something, do a particular thing, or carry on a trade.
In other ways, it is freedom to behave as one wishes, particularly in a way which results in excessive or unacceptable behavior.

Multiple Exchange Rates

The continuation of more than one exchange rate for a specified pair of currencies. This is infrequent today, this used to be common in countries with widespread capital controls, which also set different exchange rates for different reasons.

Import Deposits

A requirement that importers put some amount of money in an account for some period of time.
In other ways, it is a percentage of the value of an import that a country’s customs authority necessitates the importer to deposit for a brief period of time.

Quantity Controls

Quality control is the procedure of put into effects policies that make sure that goods and services produced meet the set standards and regulations. This procedure is extensively appropriate in business and the production industry.

Quality control (QC) is a process or set of procedures proposed to make certain that a manufactured product or performed service adheres to a distinct set of feature.

Forecasting Exchange Rate Movements

  • Fundamental Forecasting uses trends in economic variables to predict future rates.
  • Technical Forecasting uses past trends in exchange rates themselves to spot future trends in rates.

Factors to Control Foreign Exchange

Institutional Setting

  • Does the currency float, or is it managed?
  • Is it pegged to another currency, to a basket, or to some other standard?
  • What are the intervention practices? Are they credible? Sustainable?

Fundamental Analyses

  • Does the currency appear undervalued or overvalued in terms of PPP, balance of payments, foreign exchange reserves or other factors?
  • What is the cyclical situation in terms of employment, growth, savings, investment and inflation?
  • What is the prospect for government monetary, fiscal and debt policy?

Confidence Factors

  • Expectations with respect to political environment?
  • Credibility of the government and central bank?


  • Are there national or international incidents in the news?
  • Possibility of crises or emergencies?
  • Government or other important meetings coming up?

Technical Analyses

  • Trends in charts? Signs of reversals?
  • Overbought? Oversold?
  • What are the thinking and expectations of other market players and analysts?

Business Implications to Foreign Exchange Change

Marketing Decisions

Strengthening of a country’s currency value could create problems for exporters.

Production Decisions

Companies like to locate production in weak currency country.

Financial Decisions

Exchange rates can influence the sourcing of financial resources.
MNCs like investment in countries with prospect to appreciate the home currency.

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