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Sem 5 Prep
← Money & BankingWhat sets the exchange rate

Formulas for this chapter

Law of one price

P_domestic = E x P_foreign E = P_domestic / P_foreign

When two prices for the same good are given in different currencies and you need the rate, or when a rate is given and you must test whether the law holds.

E
Exchange rate, units of one currency per unit of the other; write the units before dividing
P_domestic
Price of the identical good in the domestic currency
P_foreign
Price of the same good in the foreign currency

Purchasing power parity

Domestic price level up 10% => domestic currency down 10% Parity rate = domestic basket price / foreign basket price With inflation in both: new rate = old rate x (1 + i_domestic) / (1 + i_foreign)

Long-run exchange-rate questions. What matters is relative inflation, so never apply the domestic rate alone when both are given.

i_domestic
Domestic inflation over the period
i_foreign
Foreign inflation over the same period

Tariff pass-through

Landed price = foreign price x exchange rate Post-tariff price = landed price x (1 + tariff rate)

Trade-barrier questions. Apply the tariff to the landed rupee price, not to the foreign-currency price, and then ask what has happened to the demand for foreign currency.

tariff rate
Ad valorem duty as a fraction of the landed value

Currency demand from a trade flow

Foreign currency needed = quantity x foreign unit price Domestic currency to be exchanged = that figure x exchange rate 1 crore = 10 million

Import-demand and export-demand questions. Use the net flow when both imports and exports are given, because export receipts are sold back into the domestic currency.

net flow
Imports less exports, in foreign currency
Step 1 of 24
The ideaTheory

The same thing cannot cost two prices

Two shops on the same street sell the same bag of rice, one at ₹60 and one at ₹90. Nobody buys the ₹90 bag. The prices converge.

Now put the two shops in different countries with different currencies. The prices can only converge if the exchange rate does the converging.

That single idea is the whole of this chapter. If a good has one world price, the exchange rate is whatever number makes the two local prices agree.

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