The Determinants of Rate of Exchange

The determination of foreign exchange rate can be traced from two theories of exchange rates.

  1. The Mint Power Parity
  2. Purchasing Power Parity

The Mint Power Parity relates to equating standard coins of different countries in terms of their weights and firmness. Under the gold standard, the mint power parity was fixed by using the weight of gold. Gold was the recognized international currency and where different units were used the nominal rate of exchange reflected their relative gold values as fixed by the metallic content of the standard coins of two countries. The major problem with the mint power parity was that economies had to use the same metallic content for their currency. If two countries were using different metallic content for their currency, it was not possible to arrive at a mint power parity exchange. Purchasing Power Parity This means that the rate of exchange between two inconvertible paper currencies is the relative purchasing power of the two currencies in their respective countries e.g. Kshs notes; Ushs notes i.e. the ratio of the home power of the two currencies in terms of goods and services. Bread – 400g K – 20/= Bread – 400g U – 80/= Purchasing power parity is realistic. However (PPP) suffers the following limitations

  1. The normal value of any two currencies in terms of each other is determined by the rates between the average prices in the two countries of those commodities that enter into international trade. Under purchasing power parity (PPP) currencies are valued for what they would buy. However this is only valid under a free trade regime and in respect of goods and services that enters into international trade. In practice, differences in prices arise from transport costs tariffs and other types of taxation.
  2. A change in the exchange rate may come about independently of the internal price level. For example, an increase in national income may decreases the value of imports relative to exports and the exchange rate of the local currency may fall.
  3. The present value of paper currency is governed to some extend by estimates of its future value. If the future value is expected to be high its present value will rise.
  4. The relative price level governs only the equilibrium rate of exchange. At any given time the actual market rate may diverge from the equilibrium rate according to the terms of balance of payment at the time. The purchasing power parity explains the ultimate long run rather than the immediate forces determining the rate of exchange.
  5. The purchasing power parity assumes that the changes in the price of goods that enter into international trade are followed by similar changes in the prices of allother goods. But it is known that the forces that determine the price of one good may differ to those that determine the price of another. The foreign exchange market is dominated by speculative influences which tend to deflect the market rate of exchange from the normal or equilibrium rate.

Factors that Affect the Supply and Demand of Foreign Currency

The market rate of exchange is determined by the demand for and supply of foreign exchange arising from the imports and the exports and the exporting goods and services. The demand for and the supply of foreign currency depends on:

  1. Trade conditions
  2. Stock exchange influences
  3. Banking influences
  4. Speculative influences
  5. Currency condition

Trade conditions

The exchange rate is determined by the balance of payment. A country facing a deficit in her balance of payment finds the demand for foreign exchange exceeding its supply and the exchange rate moving against her. A country with a surplus in her balance of payment finds the supply of foreign exceeding demand, the price of the local currency raises above par i.e. it exchanges at a premium.

Stock Exchange Influences

These include investment and speculation in international securities and the grant of loan by one country to another. Loans by Britain to Kenya or the purchase by Britons of securities on the Nairobi Stock Exchange would give Kenyans the right to withdraw funds from London. This will increase the claims against Britain and deflate the value of British currency in Kenyan shilling. The payment of interest on loans made by British and the investment by other nations in British securities would increase British claims on other nations and thus increasing the value of British currency.

Banking Influences

This includes investment by banks in other countries. Banks also issue of Letter of Credit and their arbitrage operations involving the buying and selling of foreign currency with a view to making profit later on. These days banks issue travelers cheques, letters of credit etc., these increase foreigners claim on the country of issue and to that extend influence the exchange rates against it.

 Speculative Influences

Speculative influences are the outcome of the purchases and sale of foreign currencies by speculators in the expectations of a rise or fall in their value with a view to making profit. The action of speculators influence exchange rates

Currency Condition

Foreigners judge the value of a currency in terms of its purchasing power as indicated by the general price level. The greater the purchasing power of the currency unit, the higher the price they are willing to pay for it. Inflation lowers the purchasing power of the currency unit and moves the exchange against the inflated currency.



The Bretton wood institutions

The Bretton Woods Institutions are the World Bank, and the International Monetary Fund (IMF). They were set up at a meeting of 43 countries in Bretton Woods, New Hampshire, USA in July 1944. Their aims were to help rebuild the shattered postwar economy and to promote international economic cooperation. The original Bretton Woods agreement also included plans for an International Trade Organization (ITO) but these lay dormant until the World Trade Organization (WTO) was created in the early1990s. The creation of the World Bank and the IMF came at the end of the Second World War. They were based on the ideas of a trio of key experts – US Treasury Secretary Henry Morgan thau, his chief economic advisor Harry Dexter White, and British economist John Maynard Keynes. They wanted to establish a post war economic order based on notions of consensual decision making and cooperation in the realm of trade and economic relations. It was felt by leaders of the Allied countries, particularly the US and Britain, that a multilateral framework was needed to overcome the destabilizing effects of the previous global economic depression and trade battles. In his opening speech at the Bretton Woods conference, Henry Morgan thau said the “bewilderment and bitterness” resulting from the Depression became “the breeders of fascism, and finally, of war”. Proponents of the new institutions felt that global economic interaction was necessary to maintain international peace and security. The institutions would facilitate, in Morgan thau’s words,”[the] creation of a dynamic world community in which the peoples of every nation will be able to realize their potentialities in peace”. The IMF would create a stable climate for international trade by harmonizing its members’ monetary policies, and maintaining exchange stability. It would be able to provide temporary financial assistance to countries encountering difficulties with their balance of payments. The World Bank, on the other hand, would serve to improve the capacity of countries to trade by lending money to war-ravaged and impoverished countries for reconstruction and development projects. The chief features of the Bretton Woods system were:

  • An obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar
  • The ability of the IMF to bridge temporary imbalances of payments. However, the Bretton Woods system collapsed in the early 1970s and by 1973the Bretton Woods system of fixed exchange rates had been abandoned. This led to the emergence of a new international monetary framework. The main features of the current international monetary system are that:
  • The exchange rates are freely floating, determined by market supply and demand for currencies.
  • Secondly, the dollar retains its position as the world’s reserve currency.
  • Third, there is little international oversight or control over the international monetary system. The IMF is the institution that was created to play this role.
  • Another main feature of the international monetary system is that its rules, institutions and norms are guided by a particular ideology and economic model

 International Monetary Fund (IMF)

The International Monetary Fund (IMF) is an international organization that oversees the global financial system by following the macroeconomic policies of its member countries; in particular those with an impact on exchange rates and the balance of payments. It is an organization formed to stabilize international exchange. The IMF was formally organized on December 27,1945, when the first 29 countries signed its Articles of Agreement. Now, the IMF has huge influence in the world economy. It is a specialized agency of the United Nations but has its own charter, governing structure, and finances. Its members are represented through a quota system broadly based on their relative size in the global economy. The IMF has 185 member countries and its headquarter is in Washington D.C. IMF’s unit of account is SDR. The current Managing Director of IMF is a French Jew named Dominique Strauss-Kahn .

The IMF works with other international organizations to promote growth and poverty reduction. It also interacts with think tanks, civil society, and the media on a daily basis.

Objectives of IMF

  • Promote international monetary cooperation
  • Expansion and balanced growth of international trade
  • Promote exchange rate stability
  • Help establish multilateral system of payments and eliminate foreign exchange restrictions
  • Make resources of the Fund available to members
  • Shorten the duration and lessen the degree of disequilibrium in international balances of payments

The World Bank

The World Bank Group

The World Bank Group is now made up of five institutions, four of which were created after 1944, but all sharing a similar mandate, of reducing poverty and facilitating economic growth in developing countries. The original institution is the International Bank for Reconstruction and Development (IBRD), often simply known as the World Bank. Since then other institutions have been added: the International Development Association (IDA); the International Finance Corporation (IFC); the Multilateral Investment Guarantee Agency(MIGA); and the International Centre for the Settlement of Investment Disputes (ICSID). While each of these institutions possess their own governing Articles of Agreement, all of them come under the general administration of the World Bank, sharing a common Board of Governors and Board of Directors and working under the leadership of World Bank president appointed by the US government. World Bank came into existence on 27thDecember, 1945. It is the part of the United Nations with different governance structure. The World Bank is one of two major financial institutions created as a result of the Bretton Woods Conference in 1944. The International Monetary Fund, a related but separate institution, is the second. Delegates from a wide variety of countries attended the Bretton Woods Conference, but the most powerful countries in attendance, the United States and Britain, mainly shaped negotiations. World Bank conceived during World War II at Bretton Woods, New Hampshire, the World Bank initially helped rebuild Europe after the war. Its first loan of $250 million was to France in 1947 for post-war reconstruction. Reconstruction has remained an important focus of the Bank’s work, given the natural disasters, humanitarian emergencies, and post conflict rehabilitation needs that affect developing and transition economies.

Objectives of World Bank

The World Bank provides over $20 billion in assistance to developing and transition countries every year. The Bank’s projects and policies affect the lives and livelihoods of billions of people worldwide – sometimes for the better, but very often in controversial and problematic ways. The World Bank isn’t like the usual conventional banks. A single person cannot open an account or ask for a loan. Rather, the Bank provides loans, grants and technical assistance to countries and the private sector to reduce poverty in developing and transition countries. World Bank background and objectives have expanded and evolved over the years. The original purpose and objectives as the International Bank for Reconstruction and Development was a facilitator role in post-war reconstruction. Since 1944, this role has expanded and World Bank’s objectives have grown to develop its current mandate to alleviate worldwide poverty. They work closely with their affiliate , the International Development Association.

With all this expansion and growth, World Bank’s original focus has not changed. Today, reconstruction remains a top priority in such situations as natural disasters, needs affecting developing economies, post conflict rehabilitation and needs affecting a transitioning economy.

Impacts of Bretton Woods Institution


The IMF oversees the international monetary system and monitors the financial and economic policies of its members. It keeps track of economic developments on a national, regional, and global basis, consulting regularly with member countries and providing them with macroeconomic and financial policy advice. Surveillance covers a range of economic policies, with the emphasis varying in accordance with a country’s individual circumstances:

  • Exchange rate, monetary, and fiscal policies. The IMF provides advice on issues such as the choice of exchange rate policies and ensuring consistency between the regime and fiscal and monetary policies.
  • Financial sector issues are receiving elevated coverage in surveillance reports, building on the achievements under the Financial Sector Assessment Program (FSAP), which enables the IMF and the World Bank to gauge the strengths and weaknesses of countries’ financial sectors.
  • Assessment of risks and vulnerabilities stemming from large and sometimes volatile capital flows has become more central to IMF surveillance in recent years.
  • Institutional and structural issues have also gained importance in the wake of financial crises and in the context of some countries’ transition from planned to market economies. The IMF and the World Bank playa central role in developing, implementing, and assessing internationally recognized standards and codes in areas crucial to the efficient functioning of a modern economy such as central bank independence, financial sector regulation, and policy transparency and accountability.

Technical Assistance

To assist mainly low- and middle-income countries in effectively managing their economies, the IMF provides practical guidance and training on how to upgrade institutions, and design appropriate macroeconomic, financial, and structural policies. The IMF provides technical assistance and training mainly in four areas: Monetary and financial policies (monetary policy instruments, banking system supervision and restructuring, foreign management and operations, clearing settlement systems for payments, and structure development of central banks);

  • fiscal policy and management (tax and customs policies and administration, budget formulation, expenditure management, design of social safety nets, and management of domestic and foreign debt);
  • compilation, management, dissemination, and improvement of statistical data; and
  • economic and financial legislation. The World bank provides technical assistance by:
  • Through economic research and data collection on broad issues such as  the environment, poverty, trade and globalization,
  • Another is through country-specific, non-lending activities such as economic
  • and sector work, where it evaluates a country’s economic prospects by examining its banking systems and financial markets, as well as trade, infrastructure, poverty and social safety net issues,

The World Bank also draws upon the resources of its knowledge bank to educate clients so they can equip themselves to solve their development problems and promote economic growth.


The IMF provides loans to countries that have trouble meeting their international payments and cannot otherwise find sufficient financing on affordable terms. This financial assistance is designed to help countries restore macroeconomic stability by rebuilding their international reserves, stabilizing their currencies, and paying for imports—all necessary conditions for launching growth. The IMF also provides concessional loans to low income countries to help them develop their economies and reduce poverty.

Main lending facilities

1. Stand-By Arrangement (SBA)

In an economic crisis, countries often need financing to help them overcome their balance of payments problems. Since its creation in June 1952, the IMF’s Stand-By Arrangement (SBA) has been used time and again by member countries; it is the IMF’s workhorse lending instrument for emerging market countries. Rates are non-concessional, although they are almost always lower than what countries would pay to raise financing from private markets. The SBA was upgraded in 2009 to be more flexible and responsive to member countries’ needs. Borrowing limits were doubled with more funds available upfront, and conditions were streamlined and simplified. The new frame work also enables broader high-access borrowing on a precautionary basis.

2.  Flexible Credit Line (FCL)

The Flexible Credit Line (FCL) is for countries with very strong fundamentals, policies, and track records of policy implementation. It represents a significant shift in how the Fund delivers Fund financial assistance, particularly with recent enhancements, as it has no ongoing (ex post)conditions and no caps on the size of the credit line. The FCL is a renewable credit line, which at the country’s discretion could be for either one- or two years, with a review of eligibility after the first year. There is the flexibility to either treat the credit line as precautionary or draw on it at any time after the FCL is approved. Once a country qualifies (according to pre-set criteria), it can tap all resources available under the credit line at any time, as disbursements would not be phased and conditioned on particular policies as with traditional Fund-supported programs. This is justified by the very strong track records of countries that qualify to the FCL, which give confidence that their economic policies will remain strong or that corrective measures will be taken in the face of shocks.

3. Precautionary Credit Line (PCL)

The new Precautionary Credit Line (PCL) is also for countries with sound fundamentals and policies, and a track record of implementing such policies.

While they may face moderate vulnerabilities that may not meet the FCL qualification standards, they do not require the same large-scale policy adjustments normally associated with traditional Fund-supported program. The PCL combines pre-qualification (similar to the FCL), with more focus edex-post conditions that aim at addressing the identified vulnerabilities.

Progress is assessed in the context of semi-annual monitoring over a one to two year period. The size of the credit line allows access to a larger amount of resources than under a typical SBA. While there may be no actual balance of payments need should at the time of approval, the PCL can be drawn upon should such a need arise unexpectedly.

4. Extended Fund Facility

The Extended Fund Facility is used to help countries address balance of payments difficulties related partly to structural problems that may take longer to correct than macroeconomic imbalances. A program supported byan extended arrangement usually includes measures to improve the way markets and institutions function, such as tax and financial sector reforms, privatization of public enterprises.

5. Trade Integration Mechanism

The Trade Integration Mechanism allows the IMF to provide loans under one of its facilities to a developing country whose balance of payments is suffering because of multilateral trade liberalization, either because its export earnings decline when it loses preferential access to certain markets or because prices for food imports go up when agricultural subsidies are eliminated.

Fund Generation

International Bank for Reconstruction and Development (IBRD) lending to developing countries is primarily financed by selling AAA-rated bonds in the world’s financial markets. While IBRD earns a small margin on this lending, the greater proportion of its income comes from lending out its own capital.

This capital consists of reserves built up over the years and money paid in from the Bank’s 185 member country shareholders. IBRD’s income also pays for World Bank operating expenses and has contributed to International Development Association (IDA) and debt relief. IDA is the world’s largest source of interest-free loans and grant assistance to the poorest countries.

IDA’s funds are replenished every three years by 40 donor countries. Additional funds are regenerated through repayments of loan principal on 35-to-40- year, no-interest loans, which are then available for re-lending.

 Trust Funds and Grants

Donor governments and a broad array of private and public institutions make deposits in Trust funds that are housed at the World Bank. These donor resources are leveraged for a broad range of development initiatives. The initiatives vary significantly in size and complexity, ranging from multibillion dollar arrangements—such as Carbon Finance; the Global Environment Facility; the

Heavily Indebted Poor Countries Initiative; and the Global Fund to Fight AIDS, Tuberculosis, and Malaria—to much smaller and simpler free standing ones. The Bank also mobilizes external resources for IDA concessionary financing and grants, as well as funds for non-lending technical assistance and advisory activities to meet the special needs of developing countries, and for co-financing of projects and programs. Direct World Bank grants to civil society organizations emphasize broad-based stakeholder participation in development, and aim to strengthen the voice and influence of poor and marginalized groups in the development process.

 Capacity Building

Another core function is to increase the capabilities of the partners, the people in developing countries, so as to help them acquire the knowledge and skills they need to provide technical assistance, improve government performance and delivery of services, promote economic growth and sustain poverty reduction programs. Linkages to knowledge-sharing networks such as these have been set up by the Bank to address the vast needs for information and dialogue about development. The Bretton Woods institutions (The IMF and World bank) was an agreement to stabilize currencies and avoid restrictive exchange practices. It provided short-term liquidity to members with current account deficits, conditioned on their taking measures to restore balance of

payments equilibrium. The World Bank was intended to make loans and guarantees for post–World War II reconstruction and for economic development. However, they have been subjected to a variety of criticisms in recent years and have been faced with severe problems in carrying out their objectives. The International Monetary Fund (IME) and the World Bank have not performed in accordance with the original intentions of their founders.

For example, in recent years, a major problem has been the financial crises of member countries that have liberalized their economies in line with trends toward globalization. These crises have resulted in demands on the IMF and World Bank for financial assistance for purposes other than those for which their assistance was originally designed. Other problems of the two institutions include providing assistance to the world’s poorest countries that have made virtually no development progress in recent years, and assisting the former communist countries in transition to market economies.

According to the Bretton Woods Agreements, the IMF was designed to assist a member country in financing its current account deficit while implementing policies to restore balance of payments equilibrium. Monetary and fiscal restrictions and exchange rate adjustments usually require several years to correct a current account deficit. Also, there is a close relationship between policies that affect the balance of payments and those that promote economic development. Therefore, both functions should be carried on by a single institution represented by a merger of the IMF and the World bank.

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