Summary

Economics Class 44

EXCHANGE RATE POLICY (05:02 PM)

This was basically the Bretton Woods system where the US was linking its currency with gold.
In the 1950s, demand for Dollars started increasing.
Countries also started stocking dollars.
Bretton Woods system can also be seen as a Fixed Exchange Rate system.
Fixed Exchange rate means the exchange rate of the currencies will be decided by the Government.
The Bretton Woods system was an international monetary agreement that standardized currency exchange rates. Currencies belonging to various nations were pegged against the US dollar. The US dollar itself was pegged against the price of gold.
It aimed to bring uniformity to global exchange rates. It was based on the gold standard. This system regulated international trade between 44 countries and remained in practice from 1945 to 1973. The system collapsed because the US dollar could not hold its value.
The gold standard refers to a monetary system where a nation’s currency is valued according to a specific quantity of gold. Under the system, the value of paper notes was standardized in terms of gold.
Characteristics of the Bretton Woods system:
Stabilizing international exchange rates was the primary objective of Bretton Woods.
It was an attempt to help nations recover economically post-World War II.
Bretton Woods was adopted by 44 countries—they agreed to peg their currencies against the USD.
The US Dollar was considered—an international reserve currency.
It provided a fixed exchange rate. However, this rate was adjustable.
It standardized international monetary payments—by facilitating currency conversion.
Post Bretton Woods, allied countries did not have any control over the international payment and settlement system.
Collapse of Bretton Woods System:
Between 1968 to 1973, Bretton Woods was on its way out. US President Richard M. Nixon ceased USD-gold convertibility. In the 1960s, the US dollar struggled to hold its value.
Nixon noticed that the US was short on gold. US’s Gold reserves could not meet the value of dollars in circulation. Economists’ attempts to revitalize Bretton Woods failed. In 1973, the Bretton Woods agreement collapsed—it ceased to exist.
The Bretton Woods arrangement failed due to the following reasons:
1. The system depleted US gold reserves—as more and more US dollars were issued to meet international demand.
2. In the 1960s post-Vietnam War, the US struggled with inflation. Its current account balance was low; thus, the government decided to call off this system.
3. Moreover, this system lacked a proper adjustment mechanism for the balance of payments.
4. There was a deficit balance of payment in the US. Meanwhile, there was a huge demand for the US dollar worldwide, resulting in liquidity issues.
5. The US dollar was the international reserve currency.
This caused seigniorage issues for many other nations. Other nations believed that this system provided an undue advantage to the US. USD yielded a higher rate of return when sold internationally and lesser when sold domestically.
6. Finally, in response to inflation and the current account balance deficit, the government declared restrictions on gold-dollar conversions.

FLEXIBLE EXCHANGE RATE SYSTEM (05:20 PM)

Here the currencies are decided based on demand and supply.
It means things are left to the market.
Suppose there is Quantitative easing followed in the US, the Dollar supply increases, so loans become cheaper.
Investors will have a lot of money to invest.
So, there is more scope for External Commercial Borrowing.
There can be more FDIs, and FIIs coming into India.
Therefore, more dollar circulation in India.
Automatically, RBI's monetary stance will also change.
Even exchange rates are based on demand and supply.
When there is movement of capital out of India, this means the supply of the dollar is decreasing, will mean the rate has increased.
So, RBI should increase the supply of dollars into the market which is known as sterilisation activity.
So, Currency values are decided based on demand and supply.
A flexible exchange rate means that the currencies are left to the forces of demand and supply.
However, we used a managed floating system or dirty float.
This means to a major extent the currency is left to market forces of demand and supply.
But suppose the rupee value depreciates up to a decided limit, then RBI intervenes.
RBI will intervene through sterilisation.
Depreciation is used there is a flexible exchange rate system.
Appreciation means increasing the value of currency.
Revaluation or devaluation happens in a fixed exchange rate system.
Over-appreciation of currencies making exports non-competitive leads to Dutch disease.

EXCHANGE RATE MANAGEMENT IN INDIA (05:44 PM)

Liberalised exchange rate system in India:
A liberalised exchange rate management system (LERMS) was announced in the budget for 1992- 1993 that introduced partial convertibility of rupee.
In this system, a dual exchange rate was fixed in which 40% was to be surrendered to the official exchange rate and the remaining 60% converted at a market-determined rate.
Market-determined exchange rate regime (1993-Present Day):
LERMS was essentially a transitional mechanism and provided a fair degree of stability.
There was also a healthy build-up of reserves.
Exchange Rate:
It is a rate at which domestic currency exchanges with other international currencies like dollars in the Foreign exchange market.
Factors influencing exchange rate:
1. Political stability:
Countries with greater political stability will generally have higher currency value.
Countries with low current account deficits tend to have stronger currencies compared to those with higher deficits.
2. Inflation:
A country with high inflation typically sees depreciation in its currency.
3. Speculation:
If a particular country's currency is speculated, there will be an appreciation of currency due to increased demand.
Types of Exchange Rate System:
Fixed Exchange rate system:
The rate of exchange will be with respect to different currencies fixed by the Government.
The Government takes necessary measures to maintain the Exchange rate at the desired level.
A fixed Exchange rate system ensures stability in foreign trade by avoiding day-to-day fluctuations.
Fixed exchange rates eliminate speculative activity in international transactions.
Flexible/floating Exchange Rate:
It is the rate that is determined through the demand and supply of different currencies in the foreign exchange Market.
Under this regime, there are two different systems:
1. Free float:
Under free float, the rate of exchange is market-determined that is it is determined by the forces of demand and supply of currencies in the foreign exchange market.
2. Managed float:
It is a hybrid of fixed and flexible systems.
It is guided by the broad principles of careful monitoring and managing the exchange rate.
The central bank only intervenes in the FOREX market to restrict the fluctuation in the market rate within a specified range.
The exchange rate can move freely within the range.
In India, this regime is followed where RBI intervenes through the buying and selling of foreign currencies to maintain the exchange rate within a specified range.
It is also termed as dirty float.
Depreciation:
Depreciation occurs when the value of domestic currency falls in the international exchange market.
It occurs automatically through the forces of demand and supply.
It is found under a flexible exchange rate system.
Devaluation:
When the value of domestic currency is deliberately reduced by the Government.
It is found under the Fixed exchange rate system.
When the rupee value is depreciated, the current Account Deficit suddenly increases.
But after some time, it will start improving.
J Curve:
J Curve says that the rupee value fall will deteriorate the current account deficit and then after a certain period of time, the current account deficit will start improving.
It is an economic theory that states that under certain assumptions a country's trade deficit will initially worsen after the depreciation of its currency.
It is mainly because of the higher prices of imports increasing the trade deficit but as time progresses, exports become more attractive to foreign buyers.
Simultaneously domestic consumers purchase fewer imported products due to higher costs.
These two phenomena will shift the trade balance on a positive note after a certain period of time.

NOMINAL EXCHANGE RATE AND REAL EXCHANGE RATE (06:56 PM)

The nominal Exchange rate is equal to the value of a foreign currency expressed in terms of Domestic currency.
For example, the Value of one dollar is expressed in terms of Indian rupees.
NER means how many rupees somebody will get when he sells one dollar in the exchange market that is NER depends on market forces of demand and supply.
The nominal effective exchange rate:
It is a measure of the value of the currency against the weighted average of a basket of foreign currencies.
The currencies are weighted according to the amount of trade with that country.
If the NEER value is increasing (Index number), it indicates that the domestic currency (Rupees) is becoming costly or appreciating and that is more of these baskets of currencies have to be sold out to buy Indian rupees.
The increase in NEER indicates that India is becoming less trade-competitive (the appreciation of rupee with respect to a basket of currencies is making our exports costly)
NEER is not adjusted for inflation.
Real effective exchange rate (REER):
It is adjusted to the inflation index.
REER is considered a good measure to check the international competitiveness of a currency.
If REER is increasing, it is indicating that the Indian rupee appreciating with respect to the basket of currencies.
Purchasing power parity exchange rate:
Let's consider an example where an ice cream costs 35â¹ rupees in India and the same ice cream can be purchased at 1$ in the US.
The PPP exchange rate in the above case is arrived at by comparing prices of ice creams in both countries that is 1$=35â¹ is the PPP exchange rate which can also be written as â¹35 per $ which implies whatever rupees 35 can be purchased in India, the same items can be purchased in the US for 1$ that is Purchasing power of â¹35 in India is equal to purchasing power of 1$ in the US.
PPP exchange rate = Domestic price/ Foreign price that is here â¹35/1$
The trade competitiveness of a country is decided by real Exchange rates.
India's trade competitiveness = Price of ice cream in the US X nominal exchange rate/ price of ice cream in India that is equal Nominal exchange rate/( Price of ice cream in India/Price of ice cream in the US) that is equal to Nominal exchange rate/PPP exchange rate which is equal to the real Exchange rate.
Mathematically,
RER= (NER/PPP).

The topic to be discussed in the next class- Convertibility of currency and IMF.