Q.23(A). Define the term rate of exchange.
Q.23(B). Explain how the rate of exchange is
determined?
RATE OF
EXCHANGE
The rate at which the currency or
monetary unit of one country can be exchanged with the monetary unit of other
country is called the rate of exchange. In other words, the rate at which a
unit of one country exchanges for the currency of another is the rate of
exchange between them. It may be used to denote the system whereby the trading
nations pay off their debts.
Determination of Rate of Exchange
The rate of exchange is determined
under the following under the following money systems as:
Under Gold
Standard
If two currencies are on gold
standard and if their currencies are expressed in terms of gold i.e. a certain
weight of gold then the rate of exchange is determined by reference to the gold
contents of the two currencies. Suppose Pakistan and United States are on gold
standard the rupee being equal to 10 grams of gold and dollar consisting of 50
grams of gold. The rate of exchange between the two countries will be
1 Rupee = 10/50 = 1/5 $ or 0.20 cents
1 Dollar = 50/10 = 5 Rupees.
Thus the rate of exchange is
determined in a direct manner by comparison between the gold contents of the
two countries. This rate of exchange is also known as Mint Par of Exchange. The
actual rate in the foreign exchange market will be slightly different from the
mint par to allow for certain expenses. However the actual rate of exchange
between 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 called Gold
Points.
Under Paper
Currency Method
This phenomenon of exchange rates
determination is also called Purchasing Power Parity Theory. No country in the
world is rich enough to have a free gold standard. All countries nowadays have
paper currencies. According to this theory the rate of exchange between two
countries depend upon the relative purchasing powers of their respective currencies.
Such will be the rate which will equate the two purchasing powers.
For example if a certain assortment
of goods can be purchased for ₤ 1 in Britain and a Similar assortment of goods
with Rs. 16 in Pakistan then the purchasing power of ₤ 1 is equal to the
purchasing power of Rs. 16. Thus the rate of exchange according to purchasing
power parity theory will be
₤ 1 = Rs.16
₤ 1 = Rs.16
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