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Exchange Rate Systems
Welcome friends to our course on International Business. So, in the last lecture we havewe are discussing about foreign Exchange Rate Systems and in which we talked aboutthree basically, exchange rate system; one being the fixed exchange rate right and thenwe talked about the which is another which is close to the fixed exchange again thecalled the pegged system and then the floating system right.(Refer Slide Time: 00:41).So, generally you find some authors talking about fixed and floating rate system which isalso correct. So, the pegged is more like the fixed exchange rate system. So, wediscussed that in the fixed exchange rate as the name suggests the government tries tokeep it constant right.So, what it says? The exchange rates are either held constant or allowed to fluctuate onlywithin very-very narrow boundaries right. So, what are the advantage of a fixedexchange rate system? As the name from the name you can understand it is very simple.There in a fixed exchange rate environment, the corporations maybe able to engage ininternational trade direct foreign investment and international finance without worryingabout the future exchange rate since, it is simple and very clear right. So, suppose I knowthat the it is a fixed exchange rate. So, in the future also I know it would be the samevalue. Suppose, Indian 1 dollar is equal to 70 rupees as of today let us say and then I if Igo for a fixed exchange rate system for any transaction so; that means, we would do thebusiness on basis of this 70 rupees and we are not worried about whether it changes ornot right.So, we would like to keep it constant right, but this is an if this is an advantage, becauseit is simple and clear, there is also a disadvantage right. So, what are the disadvantage?There is a risk that the government will alter the value of a specific currency right.Some or other the time the government will try to change it, because looking at theirperspective, their benefit, the kind of advantage they can get, they would like to changethe value of the exchange rate the currency right. So, in such a condition it becomesdifficult if you are following a fixed exchange rate system. Each country may becomemore vulnerable to the economic conditions in other countries like inflationary problem.That means with the change in the economic condition in other places andcorrespondingly the country may become more vulnerable. So, it would like to change itsyou know, exchange rate right. So, in that condition also there is a disadvantage becauseyou are fixed you cannot move right. The third biggest problem is that if investors knowfor example, that a government might intervene to buyback currency to maintain itslevel; because since the government wants to keep at a fixed rate it has it will buy backthe currencies from the market right.So, the investors what they will do? They might sell the extra currency in order to makea short term profit. So, speculators will be highly active and they would like to make theyou know situation take advantage of the situation that the government may surely try tobuy the extra currency from the market. So, they would like to make a business out of itand try to take advantage. So, these are the you know the adverse impacts of a fixedexchange rate system.(Refer Slide Time: 03:54).Then after that comes the pegged exchange rate right, which is called pegging basicallypegs right. So, what is pegging? The currency’s value is pegged to a foreign currency toa foreign currency or to some unit of account, and thus moves in line with that currencyor unit against other currencies right. Let us see some governments peg their currency’svalue to that of a stable currency.Now, a stable currency is maybe dollar right, because that forces the value of theircurrency to be stable right. Let us take this example in 1994 Mexico, central bank peggedthe peso to the US dollar, but allowed a band within which the peso’s value couldfluctuate against the dollar right.That means, sometimes it becomes simple for the international business to peg your or;that means, to fix your currency against another strong currency right. So, any stablecurrency as the dollar or the euro right, anything right. So, but in order to keep someflexibility some variation, to allow some variation a small ceiling is allowed right. By theend of the year, there was substantial downward pressure on the peso and the centralbank allowed the peso to float freely, but because there was substantial pressure on thepeso the Mexican government a central bank allowed the peso to float freely, becausethey found the fixed exchange rate without the pigging system was not working for themright.(Refer Slide Time: 05:31)Now, what are pegs? Let us see. Pegged exchange rate implies that the governmentprobably will exercise, it is right at some points to move the peg; that means, when youare fixing it against some stable currency pegging means that you can change the pegthat you can fix you can change the position in some point of time right. So, thegovernment according to its requirement can exercise its right to move the peg. Pegmeans just a point which can be fixed which can be moved right.Now, what is this adjustable peg? Let us see. It implies that the government will adjustthe level of the peg as required in the face of substantial fundamental changes in thecountry’s international position.Now, basically if we simply understand if to make it very simple. A peg is somethingwhere you are trying to compare or you know position yourself against another currencywhich you feel is more less volatile or more stable right.In the crawling peg the exchange rate is changed very often. So, one is adjustable peg theother is crawling peg. So, here the exchange rate is changed very often, but only byofficial reevaluation right re-evaluation. The best of both worlds allow some degree ofstability and control as well as some degree of flexibility the peg moves according tosome set of indicators or according to the governments monetary authority.Now, I am you must be thinking why and what factors are affecting the movement of thepeg right? So, how do they decide? See you have to just think very openly that wheneverthere is a you know international business happening alright. So, the countries standmight be the countries position might be in a positive or a negative position right,adverse position. So, according to its condition; its export condition; its import condition;it is you know it is debt; situation and all these taken together. It decides whether tomove the peg accordingly change it or what is best?Should it have a fixed exchange rate? Let us say 70 and it will not change or it shouldallow it for some changes right? Change the you know as per the you know othercurrency on which you are depending peg pegging your currency against the lesser thedollar.So, should you shift slightly, but that cannot be too much right or you want to leave itonto the open market the market forces and which will be entirely decided upon thedemand and supply. So, what you should do? So, in the last case when you saw, it waslike for example, in this case the Mexican peso they finally, they moved from a peg to apegging system or a fixed system you can say largely to a completely a floating systemright.So, several all these have their own advantages and disadvantages, but today in a veryvolatile and a very dynamic world, fixed rate systems are found to be less efficientlargely right. The central bankers set the rate much as the fed changes the discount rate.(Refer Slide Time: 08:42)Now, floating exchange rate which is entirely depending on the market. So, the floatingexchange rate are of two types; the pure float, the dirty float right. What they are? Let ussee first.(Refer Slide Time: 08:54).In a freely floating exchange rate system, the exchange rate values are determined by themarket forces without the intervention of the governments. In the fixed, what hashappening? There was a complete rigidity, complete control over the by the government,the government fixed what? How should be the exchange rate in the peg? Thegovernment allowed some flexibility in the free float. There is nothing everything isdecided by the market. The free floating exchange rate system allows completeflexibility for exchange rate movements right.A freely floating exchange rate system adjusts on a continual basis in respond to thedemand and supply. This is also known as a pure or a clean float; that means, in simpleterms it there is no intervention by the government or the banks or the central bank, it isentirely decided by the demand and supply that happens for that particular currencyright. Now,case 1; if there was an increase in the interest rates, because this is a case of UK, thiswould increase the demand of the dollar and there would be a shift to the demand 2.Now, let us see this is demand 1. So, when it was, when this was the demand right so,originally we said at 1 at this demand right and the quantity is this much. So, you see thesupply is equal to demand right, this is the condition. So, what happened? So, this is thepoint; this is the point. So, demand is equal to supply. So, at 1.5 was the you can buywith 1 pound 1.5 US dollars right.Now, when there has been an increase in the UK interest rates so, what will happen? Thedemand for or the demand will increase. Now, because of the change in demand there isa shift towards demand 2 right. Now, with this shift what has happened? There is a newsupply that has come up right. So, this would cause an appreciation in the exchange ratewith 1 pound; now, able to buy 1 pound now, able to buy 1.6 dollars right so that meanswhat? That pound has become stronger to the dollar right.Now, this was a case when the demand for the pound increased right. If there was anincrease in demand for the US exports now, take a third case right. The third case saysthe demand for the US exports has increased. Now, there would have to be an increase inthe you know supply of pounds to pay for them, because if you are exporting something.So, you have to pay right. So, to pay so, there would be a shift to now this SF 2 right.So, this would cause a depreciation. Now, when this is shifting to this SF2 right. Now,what has happened? So, this is the point we are talking about. So, so what has happened?Now, with this demand for the US exports, increased demand for US exports, theincrease in the pound is there to pay for them. So, there would be a shift to SF2 right. SF2 means supply of supply pound 2, this is basically right. So, situation supply to situationright.This would cause a depreciation in the exchange rate with 1 pound now, able to buy 1.4.Now, look at it what is happening. So, first case you are saying [FL] this is a case of 1.5,1 dollar equal to 1 pound is equal to 1.5, fine. Now, with the demand now, whathappened with an increase in the UK interest rate the demand shifted to this point right.So, when the demand shifted what happened? Now, the US dollar became cheap; thatmeans, the US dollar became cheap. So, at this point at this point you can see that the USdollar the demand quantity has grown so, the us dollar has become cheaper.Now, when the second case happened when the supply, the supply has increased nowwhat has happened? You need more of UK pound to pay for the US exports ok. So, insuch a condition what has happened now this supply this has moved because you needmore value so, the US dollars now value has gone up.So, Now, the pounds value has come down with the coming down of the pound againstthe dollar. Now, the new rate is at 1.4. So, with the increase or decrease of the supply anddemand, the value of one currency against the other stable currency or the other currencyalso changes. As you saw here, that at one point when it was in demand so the valuebecame stronger and the dollar became weaker and the other time when the dollar wasmore in demand so, what happened? They had to now, they depreciated right. So, this iswhat happened in the entire situation.(Refer Slide Time: 15:59)The second case in the that floating system is called managed or dirty float. Why it iscalled manage or dirty; because you are controlling. Now, let us see what it is exchangerates are allowed to move freely on a daily basis and no official boundaries exist ok;however, governments may intervene to prevent the rates from moving too much in acertain direction, too much skewness, too much skew towards one side is not good thegovernment feels.If this is done deliberately, sometimes the governments do it deliberately to gain anadvantage over their trading partners. So, this is known as a dirty float. What it says?When the government tries to you know prevent intervene and prevent the rates frommoving towards one direction, whatever it is in such a condition they want to take anadvantage over the trading partners. This is called a dirty float or managed float.This typically involves the government and the central bank deciding upon an upper andlower limit that they ideally would like the exchange rate to operate between. So, whatthey think? They would like to have a upper limit and a lower limit. I think in the nextslide we have it. The government and central bank will only intervene in the event thatthere is a danger of the upper or lower limits being breached.If there is a chance that it will breach the upper and lower limits then the for example, aswe you know the government will intervene in there. Let us see this example, yes.(Refer Slide Time: 17:28)The UK government hypothetically sets a price ceiling of 1 pound or 2 dollars and floorof 1 dollar and 1 pound right. So, so this is floor price and this is the ceiling.If there is danger that the pound has strengthened and significantly move towards theupper band that is this side right, towards the upper band. This may damage the exports,why? Obviously, it will become costlier.So, the government may intervene for example, lowering the interest rates. So, whenthey lower the interest rates. So, the value the pounds value will also come down. It willbecome less attractive. So, or increasing the pound to buy dollars right. So, this is onecase, subsequently equally, if the pound has weakened let us say has becomeconsiderably weaker. So, that imports are more expensive. So, if your pounds are lessnow weakened so that means, imports will become costlier; obviously, we havediscussed its several times.So, it creates an inflationary pressure on the domestic manufacturers and all. So, theintervention to buy the pounds or raise interest rates may keep the currency withinpermitted bands. This, the wider the band, this band this is called the band, you can seethis right in the managed float the less intervention will be required.So, what it basically says is whenever the government has to decide this band right so, ina the system so, they have to understand according to the strength or position of theircurrency, they try to fix this band and if you are constantly changing this band then it isvery difficult right.So the so, what is suggestive is generally to keep a sufficient thickness of the band sothat you know the there is not too much of intervention from the government is requiredor desired ok. So, this is what it says right. Till now, we have understood the three typesof fixed you know the exchange rate systems, the fixed exchange; so where we said it isconstant, the pegged; where you try to move slightly against the stable currency.So, you peg against the stable currency and you try to slightly move it right, then yousaid about the floating which is completely free to float, but still there is also a case whenit is naturally flowing, floating which is a good case and the other is called a pure orclean or the other is a one where the government intervenes in order to take advantage ofthe trading partner. So, that was called a dirty or a managed floating system.(Refer Slide Time: 20:21)Now, from there we move into another aspect or very important issue which is called thecurrency convertibility. Now, what is convertibility? Currency, we have understood.What is convertibility? To convert the currency from one form to the other, let us say tolike exchange rate you are here talking about how frequently or how easily can youconvert the rupees into dollars for example, right suppose, I want 5000 dollars can I get iteasily or should I need approval for that?So, when I am in a situation suppose every day you are transacting and you are makingsome business. So, in such conditions you will need more of frequently the you knowdollars or the euros or whatever it is. So, for that is your country allowing you to freelygo and convert and make your business or it wants you to express you to take permissionfor that? Why it is done? What is the impact of this? We will see in this part right.(Refer Slide Time: 21:16)So, convertibility essentially means the ability of residents and nonresidents to exchangedomestic currency for foreign currency without limit whatever be the purpose of thetransactions. The purpose could be anything, but only this is the case of fullconvertibility understand or the definition of convertibility currency. Convertibilityrefers to the freedom to convert the domestic currency into other international acceptedcurrencies and vice versa at market demand rates of exchange ok.So, this is vital and this is important in the foreign exchange market. Higherconvertibility means that a currency is more liquid right, it can be easily converted andtherefore, less difficult to trade. But suppose your currency is not convertible or very ispartially convertible then; that means, it is not that simple to transact right, but then thegovernment also has its own plans and thoughts right. It cannot make it always fullyconvertible. Why it cannot and what is the advantage? That we will see.For example, the rupee can be converted into US dollars right more easily and US dollarscan be converted into Indian currency for buying and selling of goods and services, thisis simple convertibility.(Refer Slide Time: 22:30).What is non convertibility? Also known as blocked currency. What it means? Currencythat cannot freely be converted to other currencies on the foreign exchange, market is asa result of some exchange controls is called blocked currency or non convertible.Any currency that is used primarily for domestic transactions and is not openly traded ona foreign exchange market, this usually is a result of government restrictions whichprevent it from being exchanged for foreign currencies there are several reasons formaking money blocked.Why does the government block it? Including foreign exchange regulations, governmentrestrictions, physical barriers, political sanctions or extreme high volatility, these aresome of the you know, these are only few examples of some of the currencies, which areblocked currencies; that means, they are not convertible right. You cannot easily transactwith them ok.(Refer Slide Time: 23:28)So, why do countries limit currency convertibility? That is a question which comes toyour mind and my mind right. The main reason is to preserve the foreign exchangereserves and prevent capital flight. So, what does it say; if you do not make a limitationon that or you do not curb it or not control it, there is a possibility that the foreign playerswill take away their money and they would run away from here right.So, when residents and non residents rush to convert their holdings of domestic currencyinto a foreign currency, capital flight is most likely to occur when the value of thedomestic currency is depreciating rapidly, because of hyperinflation or when a country’seconomic prospects are shaky.So, when the country’s economic condition is bad. So, the people would like to take theirmoney and run away right. So, in such a situation the government wants to control. So,that free flight is not allowed right by restricting the exchange of one money to anoutside currency, a country would try to control and keep its currency more stable right.So, hypothetically or theoretically if you look at it you might feel that why shouldanybody be making it, but every country has its own compulsion too right. It is not likeyou know you know the condition of USA is same to India right or USA is same toAfrica, because every country has its own demographics, has its own you know income;earning, possibilities, its freedom, its you know culture, everything is different.So, when you want to do something you have to look at your country’s perspective. Inthe case of a non convertible currency as you saw, the firms might turn to counter trade.So, what they can do in suppose there is a non convertible currency as you saw here rightsome of these, the firms who want to maybe you know do some transaction they can do acounter trade. A barter like agreement by which good and services can be traded tofacilitate international trade, because easy convertibility is not there. So, you can only gothrough a barter system.(Refer Slide Time: 25:32)So, these are some of the types of currency convertibility; freely convertible, externallyconvertible, non convertible. So, what does it mean? Let us see. When the country’sgovernment allows both residents and non residents to purchase unlimited amounts offoreign currency within the domestic currency with the domestic currency is called freelyconvertible; that means, you are you can freely convert it right.Externally convertible means when only the non residents may convert domesticcurrency into a foreign currency without any limitations right. So, the residents are notallowed, only the non residents. Non convertible means when neither residents nor nonresidents are allowed to convert it into a foreign currency. So, these are the three caseslet us see.(Refer Slide Time: 26:22)Non convertible example you see, capital Cuba which has peso and North Korea. So,they do not there is they do not allow any resident or non resident to exchange theircurrencies right. Non participation in FOREX market a major challenge for domesticcurrencies there. So, somebody who is into the non convertible system so, participationin a FOREX market is a challenge right, partial convertibility example India, RBIsrestriction on the inflow and outflow of capital.So, for example, if you want to make any transaction any trade you need to have acontrol or a permission from the RBI. It is simple; that means, you need there is only asome amount is allowed, but beyond this limit you need to take permission that is asmeaning as that. The third is full convertible now, example US dollars no restrictions orlimitation on the amount to be traded. So, thus this is one of the major currency traded inthe FOREX market.So, India can never be until unless a currency is fully convertible it cannot be a majoryou know, player in the FOREX market, because automatically there is a control. So, thethere is no free liquidity and it is not easily convertible.So, the international transactions cannot be done of with all the time if permissions arerequired. So, for example, US dollar is a fully convertible and that is why one of thestrongest economy ok, currencies.(Refer Slide Time: 27:49)Now, look at this case; what is then example of a partial convertibility? Now, GooglePrivate Limited reported revenues of this much right over a 15 month period from thistime at this time period. So, there was a foreign exchange of rupees 304.24 right therewas after some you know you know some money was paid in inside. So there was anforeign exchange amount which had to go out of 304.24 crore.So, from an economic point of view if any country has a large amount of other currenciesthat country will become economically sound, fine. Suppose, if India does not have USdollars for exchanging this rupees 304.24 to Google, India limited. So, at that time Indiahas to take loan of some same US dollars from maybe USA and with that they have topay an interest on it right.So, you take a loan and you pay an interest so; that means, the original cost of the valueor the value of 304, is not now 304, it has gone up right. So, it will increase adversebalance of payment. It is true with partial convertibility of rupees investment in foreigncountry has become easy, but it is also harmful for India right.So, for India’s interests we have some restrict rules for stopping outflow of fund on thename of convertibility of rupee or liberalization, but this is debatable. What I am sayingis you might not agree to that, because all the time partial convertibility, why we aresaying in Indian case, because India’s economic situation is different, India’sdemographic is different. So, in such a condition extreme liquidity or a smooth flow ofoutflow of fund is not maybe good for Indian economy.So, some control is required, so on this maybe the Indian government is still you knowthinking on a partial convertibility and at least on the current accounts we have a partialconvertibility right.(Refer Slide Time: 29:54)So, there are two popular categories of currency convertibility; namely this forconvertibility for current international transactions. So, current account convertibility,convertibility for international capital movements, capital account convertibility.So, this is how it looks like; the Current Account Convertibility, so money classifiedunder current account can be easily converted into dollar, yen, pound, rupee or anythingand under capital account, money classified under capital account cannot be easilyconverted into different currency. RBI has very strict guidelines. We do not have fullCapital Account Convertibility in India right.So, we discussed today about the foreign exchange systems, we talked about the floatingrate system and the pegged systems and then we discussed why it is essential. What Iwould like to say is we should never compare one economic condition with the otherright directly. So, when you want to say let us say America has a full let us say goes for afloating system, should India go for a floating system right, should if America goes for afull convertibility of rupee, should India go for it? It is nothing like that right.We have to look at our domestic condition, our strength of our exporters, ourmanufacturers, our supply chain mechanism, our you know our human skill productivitylevel, everything. And then find out our educational level how much do peopleunderstand, our ethical value systems right and understanding all these things takentogether only we can then decide what is best for the country right.So, there is no one policy for any you know one for every country. Every country shouldmake its own guidelines and policies accordingly right. So, that they can have a bettersituation right. So, this is all we have for today we will meet in the next lecture.Thank you very much.