Exchange Rate and how its Determine under in Convertible Paper Currency

Exchange Rate under Paper Currency

Exchange Rate under Paper Currency

Rate of exchange is a convertible rate. It is rate at which the currency unit of a country is exchange into the currency unit of another country.When the two countries are paper standard they follow the following rules.

  1. There are token coins. Paper currency is not convertible into gold
  2. There are free inflow and outflow of goods
  3. Quaintly of money of changes according to changes in the economic conditions of the country
  4. Govt. will regulate the economy with certain measure. Monitory fiscal commercial income and price
  5. Trade is free between the countries.

When the two countries are on paper standard dear rate of exchange is determine at a point where the purchasing power of their currency is qual. It is known as parity point. E.g. the price of one kg sugar in Pakistan is rupee 30 and a dollar is USA can purchase two Kg sugar. It means the purchasing power of dollar is equal to 60 rupees. The rate of exchange shell is equal to 60 rupee. Any change in the price level will change the rate of exchange. If the price of sugar rises from 30 to 35 rupees per Kg in Pakistan and the price level remains constant in USA. The new rate of exchange:

1Dollar            =          50 Rs

The rate of exchange at the parity point will be stable. If

PAK Export                            =          Imports

 Receipt                                    =          Payment

PAK Income from Trade           =          Expenditure on Trade

Supply of FE                           =          Demand of FE

Since the economy is dynamic, imports and exports always change. Some time

Imports            >          Exports                        and some time

Exports            >          Imports

In this case under such condition the balance of payment is always discourages.

Suppose:

PAK Export                            =          Imports

Receipt                                     =          Payment

PAK Income from Trade           =          Expenditure on Trade

Supply of FE                           =          Demand of FE

Under such circumstances a dollar will not be available at the parity point. (1 dollar = 60 Rs)We shall have to pay more than 60 Rs in order to get one dollar. We can also make payment by sending goods to U.S.A. It involves the cost of transport. Suppose the cost of sending 2 Kg sugar to USA Rs One. In this way a Pakistan will be ready to pay 60 Rs for a dollar. Goods may start out flowing from Pakistan and inflowing in U.S.A. It is commodity export point for Pakistan and commodity import for U.S.A. It is also upper parity point for Pakistan (60+1) and lower parity point (60-1) for USA. Rate of exchange will move between upper parity point and lower parity point in the long period. In that short period it will move along the parity point. According to the size of 

Export and Import:

Upper =          60+1                            and                              lower   =          60-1

The export of goods from Pakistan will promote the export rate and improve receipts. Balance of Payment will bend to words Pakistan and against USA. It will automatically set the balance of payment right.

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