Exchange Rate Determination and Government Intervention

The assignment delves into the determinants of exchange rates, examining the roles of inflation, political and economic stability, government debt, and terms of trade. It highlights how government intervention in foreign exchange markets can influence economic performance by stabilizing exchange rates and facilitating foreign loan repayments. Examples like China's currency management are used to illustrate these concepts.

Running head: INTERNATIONAL FINANCE
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Name of the Student
Name of the Student
Author’s Note

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Table of Contents
Introduction...................................................................................................................................2
Discussion...................................................................................................................................... 2
Main factors affecting relative prices of products.....................................................................2
Effect that induce changes in exchange rate and deviations from purchasing power parity.....3
Correlation between exchange rate and terms of trade............................................................4
Government intervention in foreign exchange (FX) market operations....................................5
Conclusion..................................................................................................................................... 6
References..................................................................................................................................... 7

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Introduction
This report gives an overview about the vital factors that affects the relative prices of
products. Relative prices of goods refer to the ratio between price of a specific good and the
weighted average of other products that are available in the marketplace. If the prices of those
specific good increases by 2% while other products decreases, then relative prices of products
increases without affecting the purchasing power parity (Melvin and Norrbin 2017). A vital part
of the difference in price of goods between the nations is terms of trade, compression of wage,
variation in exchange rate etc. The study also focuses on how this effect on relative price of
goods induces variation in exchange rate and deviations in purchasing power parity (PPP).
Volatility in relative price and exchange rate can be generated from the two sources that
include- domestic price as well as dollar value and imported price or currency value. The
correlation between the exchange rate and terms of trade (TOT) are also analyzed in this study.
Furthermore, the government intervention engaging in operations of foreign exchange market
and its impact on TOT is also illustrated in this study.
Discussion
Main factors affecting relative prices of products
Some of the vital factors that affects the relative prices of products are exchange rate,
terms of trade, purchasing power parity etc. Movements in the exchange rate changes the
relative prices if products and services. This means that if the exchange rate declines, the
relative prices of local commodities and services also declines but relative prices of
international products and services rises. However, this fluctuation in relative price leads to
increase in the nation’s exports and decline in its imports. On the other hand, increase in
exchange rate leads to increase in relative price of products as well as services while it leads to
decline in relative price of international commodities and services (Reisman 2013). Moreover,
this variation in relative price leads to decline in exports and rise in imports. In addition, the
relative prices between the two countries can also be recapitulated by means of PPP. PPP
defines that the exchange rate between the nations is equivalent to the ratio of currencies with

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respect to the purchasing power. The PPP for the particular industry’s output is the total
currency that is needed by one nation to purchase this amount of output that will equal to one
currency value of the other country. Therefore, the PPP highlights the relative prices of
products and services, which in turn makes up the sector’s output of the two nations. In
similarity with outputs, the PPP for inputs are mainly based on the relative prices of products
and services and this in turn makes up inputs of the industries. In context to this, TOT relates to
relative prices of the imported goods in account of its exported goods and hence is termed as
ratio of prices of export to its imports. In addition, the policies imposed by the government of
the respective countries that limits imports or subsidize exports usually leads to fluctuation in
relative prices of products and services. This in turn makes its attractive to either exported
goods or imported goods. Furthermore, import quotas also increases relative price of the
imported products, which in turn decreases demand.
Effect that induce changes in exchange rate and deviations from purchasing power parity
Exchange rates are mainly defined as the value in which one country’s currency could be
converted to another nation’s currency. There are several factors that influence the exchange
rate in the long run, which includes- relative levels of prices of goods, barriers in trade, total
productivity and preferences of domestic versus international products. It has been stated by
Reisman (2013) that , the variation in price level of goods also leads to variation in the foreign
exchange rate. this means that adjustment in prices of the commodities also creates changes in
the exchange rate. Furthermore, the exchange rate might also change owing to real economic
events and also with average level of prices constant. As the PPP is illustrated with the prices
indices, such changes in relative prices of commodities might cause deviations from PPP since
the exchange rate varies even though prices index remains to be constant. Even the condition
of PPP presumes that there is basically no cost of transaction. However, PPP might not hold
exactly in the existence of the transaction cost (Taylor 2013). Instead this transaction cost might
create band within which deviation from PPP might vary without setting into foreign arbitrage
of products. The main reason behind this is that in presence of this transaction cost, any
arbitrage activities might not occur for those commodities in which profit margin from arbitrage
is less than cost of transaction. Jolliffe and Prydz (2015) founds out that as the non traded good

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price enters into price index and thereby into deviation of real exchange rate from PPP.
However, this indicates that the divergence from PPP might not be constant.
Correlation between exchange rate and terms of trade
There is indirect correlation between the exchange rate and terms of trade. The TOT can
be affected by exchange rate as increase in value of the nation’s currency decreases the
domestic import prices but might not directly impact the prices of exported commodities.
Moreover, direct as well as indirect impact of exchange rate might induce variation in TOT as
well as trade volume. Depreciation of a country’s currency declines the TOT, which in turn
increases trade volume. On the other hand, appreciation in the currency value of a specific
nation increases TOT and declines the trade volume (Berman, Martin and Mayer 2012). The
export prices from the nation can heavily impact by the currency value and this in turn might be
affected by rate of interest in the nation. Furthermore, if the currency value of the specific
nation is increased owing to rise in rate of interest, it might be predicted that the TOT will
improve (OHYAMA 2013). Apart from this, the impact of variation in exchange rate on the
volume of trade is basically lower than the impact on TOT, which in turn implies that
international price elasticity of demand for import is less than one. In fact, the elasticity’s of
domestic s well as international prices for the import demand are important to decide the
exchange rate in influencing the TOT as well as trade volume. Melvin and Norrbin (2012) opines
that weaker currency value increases exports and also makes the imports highly expensive. In
addition, direct as well as indirect affect of variation in exchange rate also leads to fluctuation in
trade deficit or trade surplus. In short run, the trade balance might worsen import value in the
foreign currency. Based on the standard trade theory, it can be said that the balance of trade
(BOT) can be expected to directly impact by depreciation. This also states that BOT in the
country might rise after real exchange rate depreciation.
For example, recent evidences reflect that depreciation in US dollar declines TOT. The
indirect impact of variation in exchange rate on domestic Korean beef price becomes
equivalent to direct impact of foreign Korean beef price. As a result, the TOT might be changed

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by US dollar depreciation. The direct impact of exchange rate variation on imported beef price
is higher than that indirect impact of exchange rate on Korean beef price.
Government intervention in foreign exchange (FX) market operations
Government mainly intervenes in the foreign exchange market through implementation of
the monetary policy where the policymakers take role for influencing transfer of the monetary
fund rate of that particular currency (Noussair, Plott and Riezman 2013). The government
intervention in the FX market can be divide into two parts, which includes –
 The country which are mainly reliant on exports and hence is concerned with
appreciating value of currency, the government of respective nation might intervene.
This is because by weakening the currency value can make the export commodities
competitive in the global marketplace.
 In certain circumstances, the government intervention can be reactionary for short time
for specific event. Hence, these events can cause the country’s currency to move in
specific direction in short span of time.
The government usually intervenes in the FX market for inflecting the level of exchange
rate. Certain methods implemented by the government for affecting exchange rate includes-
 Reserving – If a particular country’s government wants to keep the original value or
decline exchange rate, then it can utilize the foreign exchange reserves (Taylor 2013).
 Changing the rate of interest- increase in rate of interest leads to rise in money flow. In
case, it does not have any effect in depressing demand , then the government can be
unwilling to decrease interest rate in order to enhance currency value.
 Borrowing- In certain situation, the government also imposes tighter monetary as well
as fiscal policy in order to reduce aggregate demand. This in turn might influence
exchange rate level.
The reasons behind government intervention in FX market are shown below-
 For correcting the market failure
 For improving the economy’s performance

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 For reversing the country’s growth in trade shortage
For example, in China, the government tries to keep their currency undervalued for making
their exports highly competitive. They do this by purchasing US dollar assets and this in turn
raises the US dollar value to China’s currency (McKinnon and Schnabl 2012).
Conclusion
It concludes from the above report that variation in relative price is one of the vital
factor that impacts on exchange rate and terms of trade. Some factors that influences FX rate
are – rate of inflation, political as well as economic stability, government debt etc. Furthermore,
government intervention in this FX market also enhances economic performance of the country
by making repayment I foreign loans and stabilizing exchange rate.

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References
Berman, N., Martin, P. and Mayer, T., 2012. How do different exporters react to exchange rate
changes?. The Quarterly Journal of Economics, 127(1), pp.437-492.
Frenkel, J.A. and Johnson, H.G. eds., 2013. The Economics of Exchange Rates (Collected Works
of Harry Johnson): Selected Studies (Vol. 8). Routledge.
Jolliffe, D. and Prydz, E.B., 2015. Global poverty goals and prices: how purchasing power parity
matters.
McKinnon, R. and Schnabl, G., 2012. China and its dollar exchange rate: a worldwide stabilising
influence?. The World Economy, 35(6), pp.667-693.
Melvin, M. and Norrbin, S., 2017. International money and finance. Academic Press.
Menkhoff, L., Sarno, L., Schmeling, M. and Schrimpf, A., 2012. Carry trades and global foreign
exchange volatility. The Journal of Finance, 67(2), pp.681-718.
Noussair, C.N., Plott, C.R. and Riezman, R.G., 2013. The principles of exchange rate
determination in an international finance experiment. In International Trade Agreements and
Political Economy (pp. 329-368).
OHYAMA, M., 2013. Exchange Rates, the Terms of Trade. Trade, Policy, and International
Adjustments, p.195.
Razmi, A., Rapetti, M. and Skott, P., 2012. The real exchange rate and economic
development. Structural Change and Economic Dynamics, 23(2), pp.151-169.
Reisman, D., 2013. The Economics of Alfred Marshall (Routledge Revivals). Routledge.
Ricci, L.A., MILESI FERRETTI, G.I.A.N. and Lee, J., 2013. Real Exchange Rates and Fundamentals:‐
A Cross Country Perspective.‐ Journal of Money, Credit and Banking, 45(5), pp.845-865.
Taylor, M.P., 2013. Purchasing power parity and real exchange rates. Routledge.