Drivers of current and capital account

Exchange rate

Lecture
Section D, E and Pgp_Fin_03

RAC Chair RAC Area Member RAC Cross-Area Member

Prof. Sumit Mitra Prof. Anubha S. Sinha Prof. Debabrata Chatterjee
Objectives of the class
 How Current and capital account balance also influences foreign exchange markets?
 Exchange rate: Nominal vs Real Exchange rate
What does it mean by change in exchange rate and how does that affect export competiviness?
Multilateral exchange rates : NEER and REER and what it signifies?

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Exchange rates

The foreign exchange market is where foreign

currencies are bought and sold.
The exchange rate is the value of one currency
expressed in terms of another currency.
e.g. Rs.60 for $1 or $0.0167 for Re. 1
Exchange rates can be expressed in terms of
either the domestic or foreign currency.
The exchange rates between two nations’
currencies will be reciprocals of one another.
Bilateral exchange rates are typically quoted
against the US dollar (USD), as it is the most
traded currency globally.
Exchange rate
An exchange rate is a relative price of one currency expressed in terms of another currency (or group of
currencies)
Exchange rates are reciprocals to each other

1 USD: 70 INR CAN BE EXPRESSED

70 (70/1) ( DOMESTIC CURRENCY/ FOREIGN CURRENCY)
OR
0.0142 (1/70) ( foreign CURRENCY/ DOMESTIC CURRENCY)

Exchange rates for the corresponding country is reciprocal

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Buying a T shirt in both countries

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Activity
If a shirt costs $50, how much would it cost in euros at an exchange rate of $1 = 0.75 euros?
50 dollars will be equivalent to .75(50) = 37.5 euros. The shirt will cost ( 37.50) dollars
1USD =0.75 euro ( foreign country EU) domestic country ( US)
Bilateral exchange rate
Domestic/ Foreign = 1/0.75 =1.33 = 50/1.33 = 37.59
Foreign /Domestic = 0.75/1=0.75 = 50* 0.75 = 37.59
Assume that now 1 euro = $1.2 If a shirt costs $50, how much would it cost in euros?
Since each euro is equivalent to $1.2, you can divide the price of the shirt ($50) by $1.2 to
calculate the price in euros.
 Domestic/ Foreign = 1.2/1 = $ 50/1.2 = 41.55 euros
Foreign /Domestic =1/1.2 =0.833 = $50*0.83 = 41.55
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• Bilateral exchange rates are visible in our daily lives and widely reported in
Bilateral the media.
• Consumers are exposed to them when they travel overseas or when they
exchange rates order goods and services from other countries.

and actors in the • Businesses are exposed to them when they purchase inputs to production
from other countries and enter contracts to export their goods and services
economy elsewhere.

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Changes in Exchange rates
Exchange-rate appreciation is an increase in the value of a currency relative to
the value of another currency.
When the Indian currency appreciates, Indian residents can buy more foreign
currency and foreigners can buy less Indian currency.
Foreign goods are cheaper for Indian residents.
Indian goods are more expensive for foreign residents.
Net exports decreases, because foreigners are buying less domestic goods
(imports) than domestic residents are selling to foreigners (exports).
Change in Exchange rates
Exchange-rate depreciation is a decrease in the value of a currency relative to
other currencies.
When the Indian currency depreciates, Indian residents can buy fewer foreign
currency and foreigners can buy more Indian currency.
Foreign goods are more expensive for Indian residents.
Indian goods are cheaper for foreign residents.
Net exports increases, because foreigners are buying more domestic goods
(imports) than domestic residents are selling to foreigners (exports).
A model of the exchange-rate market
The foreign-exchange market can be analyzed using a supply and demand model.

• Factors affecting demand:

Foreign-exchange market – Imports
Exchange rate
– Interest rates: domestic and foreign
Supply of
– Domestic Investors’ confidence in a foreign
dollars economy
• Factors affecting supply:
XR* – Exports
– Interest rates: domestic and foreign
– Foreign investors’ confidence in domestic economy
Demand • Equilibrium exchange rate and quantity of
for dollars
Q* dollars bought and sold is found at the
Quantity of dollars
intersection of supply and demand.
A model of the exchange-rate market exercise
Analyze a situation where the RBI decides to tighten monetary policy by increasing the interest
rate.

Exchange rate and net exports

Foreign-exchange market Exchange rate
Exchange rate

Supply of
Dollars, S1

S2 Xr2*

R
XR*

Demand 0 Q*
for dollars
Quantity of net exports
Q*
Quantity of dollars
The supply and demand for INR increases; More inflows and demand for INR increases and no
outflow reducing the supply of INR:
Real exchange rate( adding prices)
A) Bilateral exchange rate
The currency of domestic country expressed in a foreign country currency
Gives an idea of the strength of my currency in the medium run to that country
currency.
B) Trade also is influenced by the cost of production ( Inflation in the economy)

Real exchange rate: Real cost of domestic currency in terms of foreign currency

RER is a price of domestic good in terms of foreign good

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Formula of RER
RER = Nominal exchange rate (1/72) * Price of foreign good in foreign currency
Price of domestic good in domestic currency
T-shirt COMPARISION:
Comparison of two price indices ( Domestic and foreign)
Denominated in one currency (Numerator is made into one currency using
nominal exchange rate)
Nominal exchange Price in domestic Price in Foreign RER
rate economy (INR) country ( USD)
1/72 150 3 0.69
1/74 150 3 0.67
1/74 135 3 0.60

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What can RER signal
A rise in RER reflects appreciation of the domestic currency and a decrease in
RER denotes depreciation
It is a price which sends signals to the producers and purchasers
Producers
How much productive resources must be used between export goods and home
goods?
If RER falls: Producer finds it more profitable to exporting them rather than make
home goods
Purchasers
How much resources must be spend to purchase foreign and home goods?
If RER falls: Purchasers find it more profitable to consume domestic good rather
than foreign goods.
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Moving to multilateral exchange rate
Countries have multiple trading partners
Some currency is overvalued and some are undervalued
 A basket of currency and how is my currency performing with all of them
How is the basket determined ( Weight of trade or trade share)
To understand the average change in the value of currency we use multilateral
exchange rate
We have NEER ( Nominal effective exchange rate)

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NEER how is the omega calculated
NEER is a value of currency against a weighted average of several foreign currencies
We have two trading partners in the example
Nominal Exchange rate is defined as the price of foreign currency in terms of domestic currency
1USD/72INR and 1EUR/80INR

USD EUR Trade NEER

wieghts
1/72 1/80 0.7 0.1342
1/74 1/82 0.3 0.1306

A falling NEER is considered favourable for exporters

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REER ( bringing domestic and foreign inflation)
REER is an indicator of the competitiveness of a country’s currency with respect to
a basket of currencies, adjusted for inflation effects
India’s REER is measured as a weighted average of India’s bilateral real exchange
rates with all the countries in the basket.
Thus, REER has two components:
(i) real exchange rates
(ii) weights assigned to each currency.
It measures the number of units of a domestic good you have to pay to buy one unit
of the equivalent foreign good.

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REER: calculating using two components
NEER = (Foreign country A/Domestic country unit)ω * ( Foreign country B
/Domestic country ) ω

Relative price ratios weighted average = ( Domestic country price index/ Foreign
country A price index)ω *(Domestic country price index /Foriegn country B price
index) ω
Real Effective Exchange Rate = Nominal Effective Exchange Rate * Weighted
Average Relative Price Ratios

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NEER and REER: Some inferences
 Does this index suggests appreciation or depreciation?
The appreciation kicked in from the early months of 2014
explained by the pick-up in short-term capital inflows in anticipation of the electoral success of
the NDA government.
The robust pace of inflows was maintained till the early months of 2015.
These inflows increased the supply of foreign currencies in the Indian economy relative to the
rupee, leading to an increase in the value of the latter.
Why there is a greater appreciation for REER?
Beginning from August 2013, till November 2015,
the REER index increased by almost 15%.

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Increases in NEER can lead to similar increases in REER.
 Domestic price levels in India being higher than those of countries part of
the trade basket.
The appreciation during the last few months can be attributed to increases
in the CPI, which have significantly pushed up the REER, notwithstanding
negligible increase in NEER

https://www.financialexpress.com/opinion/indias-export-competitiveness-is-devalua
tion-of-the-rupee-the-way-forward/381485/

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