Determination of Rate of Exchange

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