Determination of Rate of Exchange Under Different Monetary Systems

Let us now see how the rate of exchange is determined under different monetary systems.

Under Gold Standard:

When two trading countries are both on the gold standard, their currencies can be converted into gold at a fixed rate.

The exchange rate between two such currencies will not depart much from the mint par, and will move between the two points of export and import of gold. These points are also called “Specie Points” or “Gold Points”.

These points are discovered by adding or subtracting the cost of transporting gold from the mint par.

If the rate of exchange goes beyond these points, gold will either be imported or exported. The mint par of exchange is discovered by comparing the real gold contents of the two currencies. Such a system does not exist anywhere now.

One Country on Gold Standard and the Other on Silver Standard:

Suppose there are two countries, one having a gold standard, say, Britain, and the other has a silver standard, say, China. How will the rate of exchange between the British pound and Chinese dollar be determined? In order to clear their dues, the Chinese importers wish to buy the British currency, which is gold, with the Chinese dollars, which is silver. Hence, the rate in Peking will depend on the price of gold in terms of silver. In the same manner, in London the rate of exchange will depend on the price of silver in terms of gold. This system also does not prevail anywhere.

Purchasing Power Parity Theory:

No country today is rich enough to have a free gold standard—not even the U.S.A. All countries have paper currencies. The exchange situation is difficult in such cases. It becomes complex when either both the countries have inconverti­ble paper currencies or one is on a gold standard and the other on an inconvertible paper standard. In such circumstances, the rate of exchange between the two currencies is determined by their respective purchasing powers.

Suppose a bundle of commodities can be purchased in India for Rs. 18 and a similar group of commodities can be purchased in Britain for £ 1. Obviously, the rate of exchange will be £ 1 = Rs. 15, for the purchasing power of £ 1 is equal to the purchasing power of Rs. 15 Such a rate is not a fixed par. It fluctuates with changes in the purchasing power of the respective currencies as measured by changes in the index number of price levels. This theory is called Purchasing Power Parity Theory.

The actual rates, however, do not necessarily correspond to the respective purchasing powers of the two currencies. This theory is only a statement of a tendency. To sum up: “At any particular time, the value of the unit of a currency in terms of another is determined by the market conditions of demand and supply; in the long run, that value is determined by the relative values of the two currencies as indicated by their relative purchasing power over goods and services.”

Modern Theory: Demand and Supply Theory:

The most satisfactory explanation of the determination of the rate of exchange is that a free exchange rate tends to be such as to equate the demand and supply of foreign exchange. For example, the external value of the rupee in Bombay depends on the demand for and supply of rupees on the foreign exchange market in Bombay.

The demand for rupees comes from those who offer foreign exchange in order to obtain rupees, while the supply of rupees comes from those people who are offering rupees to obtain foreign exchange. Indian exporters earn foreign exchange which they want to convert into rupees. They, therefore, demand rupees and supply foreign currency.

Similarly, the importers, on the other hand, supply rupees and demand foreign currency. The intersection of the sterling-supply curve and the sterling-demand curve gives the equilibrium price of Sterling that equates the amount of pound sterling offered and the amount of pound sterling demanded.

Now what lies at the back of demand for, and supply of, the foreign currency? These are the various items in the country’s balance of payments. That is why the modern theory is also called the Balance of Payments Theory of Foreign Exchange.

The demand for foreign exchange arises from the debit items in the balance of payments, whereas the supply of foreign exchange arises from credit items. The debit items relate to all payments made during a given period by the residents of the country to foreigners, and credits include all payments received during the given period from foreigners by the residents. These payments may be on any account, e.g., goods bought and sold, services rendered and received, capital borrowed or lent, and so on.

If India has a net debit, its demand for foreign exchange, say pound sterling, must exceed its supply of pounds sterling with the result that the rupee price of pound sterling will go up or, what comes to the same thing, the external value of the rupee must go down relatively to pound sterling.

The rupee becomes cheap in terms, of £. Conversely a net credit in India’s balance of payments will lead to a fall in the rupee price of £, which means a higher value of the rupee or expensive rupee relative to the £. The balance of payments theory is considered most satisfactory.

Fluctuations in the Rate of Exchange:

The long-term parity may be the mint par as under gold standard or purchasing power parity as under inconvertible paper. But, during the short period, there are various causes that may lead to fluctuations in the rate of exchange above or below this equilibrium level.

These influences can be grouped under two heads:

(a) Those affecting demand for, and/or supply of, foreign currency, and

(b) Those affecting currency conditions.

As regards (a), the demand for, and supply of, foreign currency

These arise from three sources:

(i) Trade conditions;

(ii) Stock exchange influences; and

(iii) Banking influences.

Trade Conditions:

These affect exports and imports and hence the supply of, and the demand for, foreign currency respectively. When our exports are greater than imports, exchange will tend to move in our favour, i.e., our currency will become more valuable in terms of foreign currency or the foreign currency becomes cheaper. In the opposite case, it will tend to move against us. Exports and imports here include not only visible but also invisible items.

Stock Exchange Influences:

These include raising of loans, repayment of interest and loans, purchase and sale of foreign securities, etc. When a loan is, given by the home country to a foreign country, the demand for foreign currency increases and the value of home currency tends to fall. The same is the case when home investors purchase foreign securities or foreign investors sell home securities. The exchange moves in favour of a country when its loans are being repaid or when foreigners buy her securities, because such transactions create demand for the home currency.

Banking Influences:

Under this category come the purchase or sale of bankers’ drafts, Travelers’ letters of credit, arbitrage operations (i.e., buying and selling of foreign currencies to make profit out of differences in the rates in different centres), etc. The sale of a draft on a foreign centre creates demand for foreign currency and raises its value or lowers the value of the home currency.

The bank rate also influences exchange rates. A high bank rate attracts funds from foreign sentries, and thus raises the demand for domestic currency and hence its value. In the opposite case, its value falls because funds move out of the country, thus creating a demand for foreign money.

Let us now take up the second group of factors, viz. currency conditions.

Currency Conditions:

Actual or expected changes in the value of currency also affect its exchange rate. If there is an over-issue of currency, or an over-issue is expectancy, people will not be anxious to invest their funds in such a country. In fact, funds will tend to move out. This is called ‘flight from the currency’. If people expect a currency to appreciate, they will-tend to purchase this currency for speculative gains. In the former case, the exchange rate will tend to be unfavorable and in the latter to be favourable.

Limits to Exchange Fluctuations:

But these fluctuations take place within certain limits. Under gold standard, as we have already Seen, such limits are indicated by the specie points or gold points.

Favourable and Unfavorable Rates:

A country is said to have a favourable exchange rate if the rate is nearer the gold import point, arid unfavorable if it is nearer the gold export point. The rate is also said to be favourable when the value of the home currency becomes higher in terms of the foreign currency, or when it is likely to lead’ to importation of gold on account of excess of exports over imports. If the value of home currency falls or gold tends to leave the country, the rate is said to be unfavorable.

It should be remembered, however, that the terms ‘favourable’ and ‘unfavorable’ are only technical terms coming down from the Mercantilist era What is called favourable may not be really so. For example, as compared with the exchange rate of Re 1 =65 pence, the rate of Re =7.0 pence, will be said to be favourable to India because at this rate the home currency buys more. But this rate may prove detrimental to the country’s interests is it encourages imports into India and discourages exported from India to the U.K.

Limits:

When the trading countries are on gold (or silver standard), the rate of exchange remains within the ‘Specie Points’, i.e., gold import point and gold export point. The rate of exchange does not rise above the gold import point (supposing it is quoted in foreign currency), because it becomes cheaper to the foreign importer to send gold rather than to purchase our currency.

Conversely, the rate of exchange does not fall below the gold export point, because it becomes cheaper for the home importers to make payments by sending gold out of the country rather than by purchasing foreign money.

When both the countries are on inconvertible paper, the place of the mint par is taken by the purchasing power parity. As already noted, the purchasing power parity is not fixed like the mint par, but is a moving par. Hence there are no definite limits to the movements of exchange. The fluctuations will be in accordance with changes in the demand for, and supply of, foreign currency and in the currency conditions.

Exchange Control:

In modern times, various devices have been adopted to control internation­al trade and regulate international indebtedness arising out of international dealings. The spirit of economic nationalism induces every country to look primarily to its own economic interests. It leads to unilateral action being taken by countries to regulate international trade. Exchange control is one of the devices adopted for the purpose. We study below the purpose of exchange control and the methods of doing it.

The Objective:

The chief object of exchange control is to restore equilibrium in its balance of payments. If a country finds that its balance of trade has been persistently unfavorable, then it must do something to set it right. The balance of payments must ultimately be made to balance. There are several ways of doing it, viz., devaluation of currency or its depreciation or deflation. But it may not be considered desirable to adopt any of these methods. Devaluation is supposed to damage the prestige of the country. Besides, it may lead to counter-devaluation by the rival countries. Deflation brings disaster in its wake in the form of depression and unemployment. In these circumstances, exchange control is considered to be the best.

Methods of Exchange Control:

A country adopting exchange control orders all its citizens who have a claim on foreign currency arising either out of exports or otherwise to surrender all such foreign exchange to the Central Bank. The Central Bank undertakes to supply local currency in exchange for the foreign currency so surrendered. In his way, ‘he foreign exchange, which a country can command in return for the goods and services which it has supplies to other countries, comes under central control.

This foreign exchange is then rationed out to those people who want to import goods from abroad or those who have to make payments abroad. Exchange control is accompanied by import control. Anybody and everybody are not permitted to import any commodity that he likes and from anywhere he likes.

Exchange control is adopted in times of national emergencies or to meet the requirements of planned economic development. The object of import control is to permit the importation of only those commodities which are considered highly desirable in the broader interests of the nation.

Thus; a list of priorities is drawn up, and the intending importers are asked to apply for a license for importing goods. These applications are then considered in the light of the urgent national requirements of the time. It is only among these licensed importers that the available foreign exchange is distributed. The government may utilize a part of the foreign exchange for importing some essential goods on its own account.

It is clear that the exchange control system does not permit the importation of more articles or services than we can afford to pay for. The volume of imports’ is kept within the purchasing power of the country as indicated by its volume of exports of goods and services.

Hence, the balance of payments can never become unfavorable under these circumstances. The country first exports goods and services and earns foreign exchange, and this very foreign exchange is then utilized in the financing of imports.

Exchange Control in Practice:

The system of exchange control was adopted by Germany in 1933. During the war every country controlled exchanges. We in India also adopted this system during World War II. The Reserve Bank of India was empowered under the Defence of India Rules to administer exchange control with a view to conserving foreign currencies obtained from exports for the purpose of financing essential imports.

Accordingly, all transactions in foreign exchange had to be conducted through the Reserve Bank or through the dealers (i.e., banks) authorized by it. Exchange control was instituted in respect of non-empire currencies only. Proceeds of foreign exchange from exports to hard currency areas as well as the holdings of balances in dollar and other hard currencies were compulsorily, acquired. (Hard currency is a currency which has become scarce or is in short supply and is, therefore, difficult or costly to obtain.)

These were then put in the Empire Dollar Pool which was used mostly by the U.K. to obtain supplies from the U.S.A. Even though the war was over in 1945, the exchange control system, with slight modifications, still continues in India.

This is considered essential in view of the peculiar economic situation in which India happens to be placed particularly in view of the urgent necessity of importing crude oil, capital goods and other essential commodities under the impact of the Five-Year Plans of economic development.

Consequences:

Several consequences follow the adoption of exchange control. We are familiar with black markets in goods on which the government imposes a control. As soon as a commodity is controlled, it disappears into the black market. Similarly, when foreign exchange control is introduced, black market in foreign currencies arises in which currencies are exchanged at rates other than the official rates. People who are anxious to convert their currency into another currency do not mind even losing on the transaction when the currency is not freely available in the open market.

International Monetary Fund:

The International Monetary Fund (I.M.F.) was the outcome of the Bretton Woods Conference held in the summer of 1944. The main purposes for which the I.M.F. was set up were to provide exchange stability, temporary assistance to countries falling short of foreign exchange, and international sponsoring of measures for curing fundamental causes of disequilibrium in balance of payments.

Capital Resources:

The International Monetary Fund (I.M.F.) was constituted in 1946 by subscription from members agreeing to participate in the Fund amounting to 8.5 million dollars, out of which India’s contribution was 400 million dollars. In order to meet the growing demands on Fund’s resources, members’ quotas in it have been raised several times, e.g., in 1959, 1956, 1970, 1976, 1978, 1981, 1983.

As in February 1983, the Fund’s total quotas stood at $ 98,000 million (raised from $ 66,000 million till then and as against $92 billion in 1958). India’s quota in (March 1981 stood at SDR at 1717.5 million (as compared with $ 400 million before 1959 and SDR 1145 million till November-end 1980).

This subscription was paid according to the quotas assigned to members partly in the form of gold and partly in domestic currency. A member-country is required to pay 25% of its quota or 10% of its holding of gold, whichever is smaller, in the form of gold. The resources of the I.M.F. thus consist of partly gold and partly currencies of the member-countries, and now SDR’s (Special Drawing Rights), the latter being kept in the Central Banks of the countries concerned.

Aims and Objects:

The purposes of the Fund are:

(a) To promote exchange stability,

(b) To avoid competitive exchange depreciation, and

(c) To facilitate the expansion of international trade through the conversion of national currencies into one another according to needs.

All exchange restrictions and controls, discrimina­tory currency arrangements and multiple currency practices have to be ultimately eliminated. Some restrictions, however, are still being continued by many countries which cannot yet dispense with them.

The chief function of the Fund is to purchase and sell currencies of member-countries for one another subject to the condition that the holding of no member-country’s currency should exceed 200 per cent of its quota. The member-countries can get accommodation from the Fund to the extent of 75 per cent of their quota plus an addition of 25 per cent each year subject to a maximum of 200 per cent of their quota. These conditions may be relaxed at the discretion of the Fund. Thus, a debtor country is saved from gold exports and consequent deflation (as happened under gold standard) through the help of the Fund.

As regards the rates of exchange, member-countries are required to fix parities of their currencies with gold. But these parities need not be fixed for all time. The member-countries can alter exchange value of their currencies by 10 per cent; another 10 per cent change can be brought about by the Consent of the Fund. Changes beyond this can be brought about, with the consent of the Fund, only to correct ‘fundamental disequilibria.’

The Fund does not interfere in the internal economy of member-countries. It comes to their help in a temporary difficulty in meeting an adverse balance of payments. The members can withdraw from the Fund by a simple notice in writing.

Functions:

From the brief account of the International Monetary Fund given above, it can be seen that the Fund performs three major functions:

(i) It serves as a short-term credit institution:

If any country is in a temporary difficulty in liquidating an adverse balance of payments, the Fund will come to its aid. It does not, however, undertake to supply all the foreign exchange that a country may use. All countries are supposed to have their separate monetary and foreign exchange reserves to meet their normal requirements. The Fund is not intended to supplant them, but to provide only a second line of defence in case of emergency.

(ii) The Fund provides a mechanism for improving long-term balance of payments position:

For this purpose, its rules provide for orderly adjustment of exchange rates. No member-country can indulge in irresponsible and competi­tive exchange depreciation, thus introducing the law of the jungle in interna­tional monetary relations. Whenever a country feels that its rate of exchange is out of line with its economy, the rate can be altered but only after due deliberation between the country and the authorities of the Fund.

(iii) The Fund provides machinery for international consultations:

It brings together representatives of the principal countries of the world and affords an excellent opportunity for reconciling their conflicting claims. This constructive approach and the measure of international co-operation is bound to have not only a stabilizing influence on world economy but also lead to the expansion and balanced development of world trade and world production.

Working:

As for the working of the Fund, it appears that exchange restrictions have gradually been disappearing and the member-countries have moved towards multilateral convertibility. The Fund has been giving financial assistance liberally to enable the member-countries to overcome their difficulties in respect of deficits in their balance of payments and foreign exchange difficulties. Both developed countries like the U.K. and developing countries like India have on several occasions borrowed from the I.M.F. A new era of international co-operation in monetary matters has been ushered in.

Another creditable achievement of the I.M.F. has been the adoption by it in 1970 of the novel scheme of special drawing rights, by which the shortage of gold and reserve currencies like the U.S. dollar has been sought to be made up, so that the growth of international trade can go on unimpeded.

Reform of the International Monetary System:

A nicely and diligently built up system of exchange stability by the I.M.F. seems to have collapsed like a house of cards. This was brought about by the dollar crisis created fry the adverse American balance of payments, which reached a record-breaking and back-breaking figure of $11,300 billion in the first half of 1971. A package of measures announced by the then President Nixon delinked dollar from gold and the exchange rates started floating all round.

A firm dollar-gold link and stable exchange rates had been the corner stone’s of the I.M.F., and both of them were thrown overboard. On January 16, 1975, the I.M.F. abolished the official price of gold. This put an end to the privileged role that gold had played in the international monetary system for the this fund at a low rate of interest (25 per cent) to enable them to pay their enhanced oil bills and meet balance of payments difficulties arising there from.

After hard thinking and protracted deliberations on the part of the leading members of the I.M.F., a major reform in the Articles of the Fund was agreed upon in January 1976 in Jamaica. According to it (a) the role of gold in the international monetary system was reduced from the pivotal position that the metal occupied till then; (b) the floating exchange rates system was legalized as against the fixed exchange rate system adopted at Brettonwoods; and (c) the quotas of the member countries in terms of SDR’s were raised. (India’s quota in I.M.F. has gone up from SDR’s 1145 million to SDR’s 1717.5 million) Effective from January 16, 1975, the IMF abolished the official price of gold. This put an end to the privileged role that gold had played in the international system for the past 30 years. The I.M.F. members were accordingly freed from their obligation to pay one-fourth of their I.M.F. quotas in gold.

Special Drawing Rights (SDR’s) have now taken the place of gold as the principal reserve asset of the international monetary system, so that the Fund’s transactions are now conducted in terms of SDR’s. This is indeed a reform of very far reaching importance.