Modern Exchange Rate Theory and a Sandwich Made of Dollar Bills

Rs.66.49/$, Rs.66.82/$, Rs.66.03/$, Rs.67.01/$.. Have you ever looked at the financial page of a newspaper and wondered how the value of the Rupee moves everyday? There’s a famous theory in International Finance that states that currency values are random. That is to say, their movements do not have a logic and hence, cannot be predicted.

But the general understanding otherwise is that currency rates go up and down due to two basic factors in Economics that you might have already heard of: Supply and Demand.

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(Source: Investopedia)

Before knowing how currencies move, there has to be a basic understanding of how Supply, Demand and by extension, Price are related. Supply is inversely related to Demand and Demand is directly related to Price (This also means that Supply is inversely related to Price). This is Economics. But this is the boring kind of explanation.

We can understand this phenomenon with a more interesting example. Assume that you need to have sandwich for breakfast everyday. There’s no other option. Now, would you give Rs.1000 to get that sandwich? That sound crazy, right? But what if there were only 10 sandwiches in your entire locality? Would you pay the Rs.1000, considering there are handful of other people who also want them? What if there was only 10 sandwiches in the entire country? Would you then pay Rs.5000, Rs.10000? You have to. Because you need the sandwich and the supply is low. So you are willing to pay a higher price to get it.

Now flip it around. Imagine that every other shop in your locality and millions of shops in the country sell sandwiches. Would you still pay Rs.1000? Rs.100? If a shop is selling it at Rs.50 or below, you’d probably get it from there. Why do you do this? Because the supply is humongous. If you feel that one shop has priced the sandwich higher, you can go to the next one. You have several options. You are only willing to pay the least possible price or at least a price that is comparatively very low for a good sandwich.

The same is the case with currencies, because a currency is nothing but another commodity, albeit with very different properties. In this case, the foreign currency is the sandwich.

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Let us say that the current price of the Dollar-Sandwich is Rs.67.14. Whenever more people in India demand for more Dollar-Sandwiches, the price will move to Rs.67.14, Rs.67.85, Rs.68.21 and so on, upwards. When this happens, we say that the Indian Rupee is depreciating against the Dollar (Or that the Dollar is appreciating against the Indian Rupee). When the demand for Dollar-Sandwiches fall, the the price of one Dollar-Sandwich moves from Rs.67.14 to Rs.66.98, Rs.66.02 and so on below. When this happens, we say that the Indian Rupee is appreciating against the Dollar (or that the Dollar is depreciating against the Indian Rupee).

That’s all there is to it.

This article is written by Dinesh Sairam (PGDM, XIME-B, Batch 21)

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