The term ‘rate of exchange’ expresses the price of one currency in terms of another. Thus, it indicates the exchange ratio between the currencies of two countries. Suppose for example, one Indian Rupee is equal to 13 USA Cents. This implies that in the exchange market, one Indian Rupee will fetch 13 Cents. Just as the price of a commodity is determined by its demand and supply conditions, the price of a foreign currency (i.e., the rate of an exchange) is also determined on the basis of demand and supply of the currency. In fact, the rate of exchange of a currency will keep on changing in the foreign exchange market, due to changes in demand and supply conditions of the currency. In this section we shall study about exchange rate varies under different monetary standards.
Rate of Exchange Under the Gold Standard:
Under the Gold Standard the monetary authorities are committed to a policy of converting gold into currency and currency into gold. This means, the buying and selling of gold at a specified fixed price in unlimited quantities will be allowed.
If two countries are on the Gold Standard, the rate of exchange between the two currencies concerned will be fixed on the basis of par value. This means that the monetary authorities would first establish gold value of the country‘s monetary unit. This is called par value of the currency, Buying and selling of gold will be allowed between the two countries. This will establish pars of exchange. The rate at which the currency units of one country will exchange for the currency units of the other, would depend upon the quantity and purity of gold represented by each. The ratio between the quantity of gold represented by the gold represented by the two units is termed as the mint par of exchange of mint parity. Mint par of exchange or mint parity is defined as the exact equivalent of the currency unit of one country expressed in terms of the currency unit of another based upon the weight and fineness of the metal contained in two coins according to the respective mint regulations. The mint par of exchange, hence expresses ―the number of units of one currency which should legally contain the same amount of pure metal as does (legally) a given number of units of another currency.
Rate of Exchange Under Managed Paper Standard
When the two countries are on inconvertible paper standard, there is no link with any metal, gold or silver. As such the rate of exchange is determined on the basis of demand and supply of foreign currencies. The exact rate of exchange is mainly influenced by their purchasing power parity. The Purchasing Power Parity. Theory is associated with Swedish economist Gustav Cassel. The theory states that where the exchange rate between two countries is free to move without limit, if tends to approximate to the point, where each currency will buy as many goods in the other country‘s market as in its own home market.
This can be briefly illustrated by means of an example. Suppose, a bale of cotton is sold for Rs.500 in India (price in the home-market) and the same bale of cotton is sold for 10 dollars in USA‘s market, then the rate of exchange between Rupee and Dollar will be 50 Rupees for a Dollar, ignoring transport costs. This Purchasing Power Parity theory is defective in several respects:
(a) Price in the home-market depends upon price level internally, which will be affected by the inflationary conditions in the economy.
(b) Different types of goods enter into the international trade to find the rate of exchange will be impossible.
(c) The theory wrongly assumed that changes in price level induce changes in the exchange rate. In fact, it is the exchange rate that influence the price level; and
(d) The theory does not consider the demand for foreign exchange, reciprocal demand for commodities, capital movement, etc., which will affect the exchange rate.
Rate of Exchange Under Exchange Control
The term ‘exchange control’ refers to the regulation of transactions involving foreign exchange to relieve pressure on the exchange value of a particular currency. The exchange control may take any form. In the most extreme form, it involves maintaining, for an indefinite period, an artificial value of the currency. This will be entrusted with the Central Banking authority, which will administer the exchange control legislations. In such a situation, the rate of exchange is not determined on the basis of demand and supply forces, but is fixed arbitrarily by the central authorities. To maintain that rate, all the citizens of the country are compelled to surrender foreign exchange to the Central Authorities at specified rates, and then the proceeds will be rationed among those who are in need of foreign exchange on the basis of priorities.