Exchange Rate Determination

Exchange Rate Quotations, Balance of Payments, Prices, Parities and Interest Rates
1. Foreign Exchange Rates and Quotations
A foreign exchange rate is the price of one currency expressed in terms of another currency. A
foreign exchange quotation (or quote), on the other hand, is a statement of willingness to buy
or sell at an announced rate: Quotation of banks' rates.
In the retail market (newspapers, airports, etc..) quotes are most often given as the home
currency price of foreign currency.
A Cross Exchange Rate is an exchange rate between two currencies, A and B, neither of
which is C. It can be calculated as the ratio of the exchange rate of A to the dollar, divided by
the exchange rate of B to the dollar. The following sample of formulations can be used to
calculate cross exchange rates:
US $
US $
Interbank Quotations
US dollar is major worldwide currency involved in the most of the foreign exchange
transactions. This caused professionals dealers and brokers to state foreign exchange
quotations in different ways. There have been two ways of representing foreign exchange
rates worldwide for US $. Countries use any one of these two methods to announce foreign
exchange rates in the markets.
First, majority of the countries express foreign exchange prices for one US dollar which is
known as European terms. The following quote is an example to European terms:
105.00 / US $
1 US $ : 105.00 
This quote shows the amount of Japanese Yen that can be purchased for one US $ which can
be also named as Japanese terms. Additionally, when for example, TL is expressed in terms of
US $, the quote is said to be in Turkish terms. European terms were adopted in 1978 to
facilitate worldwide trading through telecommunications.
Second, several countries express US dollar price for one unit of other currencies which is
known as American terms. The following quote is an example to American terms:
US $ 0.0095 / 
1  : 0.0095 US $
The above quote shows the amount of US $ that can be purchased for one Japanese Yen
which can be calculated by taking the reciprocal of the rate presented in European terms.
 US$ 0.0095 / Yen
Yen 105.00 / US$
American terms of presenting quotes are used for the U.K. pound sterling, the euro,
Australian dollar, New Zealand dollar and Irish punt.
Direct and Indirect Quotas
Foreign exchange rates can be expressed in terms of currencies other than US$. There are two
common methods other than European and American terms: Direct quote and Indirect quote.
A direct quote is a quotation expressing home currency price in terms of a foreign currency
where an indirect quota is a quotations expressing foreign currency price in terms of a home
currency. Consider the following rates:
EURO 1.47 / GBP
1 GBP: 1.47 EURO
This rate shows the amount of EURO that can be purchased for one British pound sterling. It
is a direct quote in EURO area showing the internal value of EURO for one unit of pound
sterling and is an indirect quote in U.K. showing the external value of British pound sterling
against EURO.
Taking the reciprocal of this quotation, we get:
GBP 0.68 / EURO
1 EURO: 0.68 GBP
This quotation shows the amount of GBP that can be purchased for one EURO. It is this time
a direct quote in U.K. showing the internal value of GBP for one unit of EURO and is an
indirect quote in the EURO area showing the external value of EURO against GBP.
Bid and Ask (offer) Quotations
Interbank quotations are given as a bid and ask. A bid is the price in one currency at which a
dealer will buy another currency. On the other hand, an offer (ask) is the price at which a
dealer will sell the other currency. To make profit, bid price is greater than ask price. The
difference between the two will give the spread (profit). Bid of one currency is the offer of
opposite currency at the same time. A trader seeking to buy $ with EURO is simultaneously
offering to sell EURO for $.
Outright quotations, that full price to all of its decimal points is given, can be given in a few
methods in worldwide video screens:
Exhibit 2.1 Outright Quotations in the Interbank Market
Method 1.
Method 2.
Method 3.
Bid – Ask (Yen/US $)
118.27 – 118.37
118.27 – 37
27 - 37
Quotes can be given in the first term (bid) as 118.27. In the second term (offer), they may be
given as 118.27 – 37 on a video screen. Or 27 to 37 assuming that leading digits (118.) are
already known. The last 2 digits are small figure frequently changing, while leading digits are
big figures seldom changing.
When quotations are converted from European terms into American terms, bid and offer
reverse. Reciprocal of bid becomes offer and reciprocal of offer becomes bid. To make a
profit, offer price should be greater than the bid price. Consider the following quotes in Table
Exhibit 2.2 Bid and Ask Quotations in European and American Terms
European Quote
American Quote
¥ 118.27 / $
$ 0.0084 / ¥
¥ 118.37 / $
$ 0.0085 / ¥
¥ 0.10 / $
$ 0.0001 / ¥
Reciprocal of bid quotes in European terms becomes ask in American terms. Spread (profit)
in European terms is ¥ 0.10 / $ in European terms where it is $ 0.0001 / ¥ American terms.
Expressing Forward Quotations on a Points Basis
Traders usually quote forward rates in terms of points (swap rates). A point is the last digit of
a quotation. Currency prices for $ are usually expressed to 4 decimal points. A point = 0.0001
of most currencies. Japanese Yen and Italian Lira are quoted to 2 points. A forward quotation
expressed in points is not a foreign exchange rate as such. It is the difference between the
forward rate and the spot rate.
Traders follow an operational rule that indicates whether forward quote is at a premium or a
discount. More specifically, if bid in points is greater than offer in points, forward rate is said
to be at a discount and points should be subtracted from spot rate. On the other hand, if bid in
points is less than offer in points, forward rate is said to be at a premium and points should be
added to spot rate. A forward bid and offer quotation expressed in points is also called a swap
rate (Borrowing a short term loan of one currency at another currency's rate).
Consider Table XX below:
Exhibit 2.3 Spot and Forward Quotations for the EURO and Japanese Yen
Euro: Spot and Forward ($/є)
Yen: Spot and Forward (¥/$)
1 Week
1 month
2 month
3 month
4 month
5 month
6 month
1 year
Source: Bloomberg, March 22, 1999. Mid-Rate is the numerical average of Bid and Ask.
Spot rates for $/є and ¥/$ quotations are given in Table XX. Point quotations of forward rates
are given for 1 week, 1-6 months and 1 year periods. Positive cash rates for the forward
market indicate that ask prices are higher than bid prices therefore they should be added to the
spot rates. Negative cash rates indicate that bid prices are higher than ask prices and they
should be subtracted from the spot rates. For example, 6 month forward rate for $/є quotation
can be calculated as follow:
Plus 6 month cash rate
6 month forward rate:
+ 112
+ 113
Here, for example, cash rate for bid price can be assumed as 0.0112 and added to the spot rate
and ask price as 0.0113. The mid rate would be average of 1.1009 and 1.1014 equaling
1.10115 which is rounded to 1.1012 in Table XX.
Forward Quotations in Percentage Terms
Forward quotations can be represented as percentage terms per annum which simply show a
deviation from the spot rates per annum. This method facilitates comparing premiums or
discounts in the forward market. The percent premium or discount depends on which currency
is the home, or base, currency. Consider the following table:
Exhibit 2.4 Spot and Forward Quotations as Percentage Terms
Quotation Given as
Foreign Currency/
Home Currency/
Home Currency
Foreign Currency
$ 1.0897 / є
є 0.9177 / $
Spot Rate
$ 1.1009 / є
є 0.9083 / $
3-month forward rate
Here EURO currency is assumed as home currency where U.S. dollar is assumed as foreign
currency. Then, percentage terms take the following forms:
Indirect Quotations (In terms of Home Currency, $/ є)
When indirect quotation is used, percentage change per annum is calculated as following:
The formula for percent premium or discount (f) =
spot  forward 360
where n represents the number of days in this case. But when for example numerator is 12, n
might be also the number of months.
The percentage change here will be:
f =
1.0897  1.1009 360
 100  4.10 % p.a.
(per annum)
For three months forward, the sign is negative indicating that the forward dollar is selling at a
1.02% per annum at a discount over EURO.
Direct Quotations (In terms of Foreign Currency, є / $)
f =
forward  spot 360
0.9083  0.9177 360
100 
100  4.10 % p.a.
For three months forward, the sign is again negative indicating that the forward dollar is
selling at a 2.32% discount per annum over the EURO. The result is the same with the
previous answer.
Percentage Changes Over a Particular Period: Calculation of Devaluation / Revaluation
If the number of periods and n is eliminated from the formulas in the previous section, then
percentage terms regarding the particular period but not per annum.
Assuming the following exchange rate for TL / $:
January – 2004
January - 2005
1 $ : 1,400,000 TL
1 $ : 2,950,000 TL
In this period, TL has depreciated against US $. And US $ has appreciated against TL.
Degree of percentage change is then =
x1  x 0
2,950 ,000  1,400 ,000
100 
100  110 .7%
1,400 ,000
Here we see that during two months’ period, US $ has appreciated against TL by 110.7 %. At
a first look, we can also say that TL has also depreciated against US $ by 110.7 % in our
everyday life. But in reality, in terms of purchasing power parity, this is not true.
Because, in terms of PPP, no currency unit can loose its value 100% or higher. Otherwise, TL
should be withdrawn from the market, meaning “zero” PP.
Degree of devaluation/depreciation =
x1 x 0
x  x1
1,400 ,000  2,950 ,000
100  0
100 
100  52 .5%
2,950 ,000
So, we can now say that TL has depreciated by 52.5% against US $. May be we’ll buy only a
bread by 1 billion TL in USA but it never reaches 99% depreciation.
Another explanation to this theory is that according to $ terms, TL depreciated by 52.5%
while $ appreciated by 110.7% according to TL terms.
1. Balance Of Payments and Exchange Rates
A nation’s economic performance is best viewed in BOP data. It is a statistical statement that
systematically summarizes, for a specified time period, the economic transactions of an
economy with the rest of the world. Economic transactions include exports, imports, income
flows, capital flows, gifts and similar one-sided transfer payments. The net of all of these
transactions is matched by a change in the country’s international monetary reserves. BOP are
important to business managers, investors, consumers, and government officials because the
data influence and are influenced by other key macroeconomic variables such as GDP,
employment, price levels, etc.. Monetary and fiscal policy must take BOP into account at the
national level. BOP helps to forecast a country’s market potential, especially in the short run.
A country experiencing a serious BOP deficit is not likely to expand imports. BOP is an
indicator of pressure for a country’s foreign exchange and for a firm for foreign exchange
gains or losses.
1.1 Measuring a Nation’s Performance: Deficits and Surpluses in BOP
BOP measures, summarizes and states all the financial and economic transactions between
residents of one country and residents of the rest of the world. If a nation receives less than
what it spends, then it incurs a “deficit”. If a nation receives from abroad more than it spends,
then it incurs a “surplus”.
Credits: Foreign Exchange Earned
Transactions that earn foreign exchange are recorded in BOP as a “credit” with a (+) sign.
Credits are obtained by selling to non-residents either real or financial assets or services. Ex.
Borrowing, Exports and foreign students university fees, etc..
Debits: Foreign Exchange Expended
Transactions that expend foreign exchange are recorded as “debits” and are marked as (-)
sign. Ex. Imports, purchasing foreign services (insurance), lending, host country student fees
for foreign schools, etc…
BOP is systematically defined and summarized by International Monetary Fund (IMF)
institution by setting up its own standard in representing BOP for the countries. According to
IMF classification of BOP, there are 43 lines representing economic transactions of the
countries. The following sections of BOP are defined based on IMF classification of BOP:
Current Account – Group A
Current account is the most liquid and important part of BOP covering transactions of trade
on goods and services, trade on services and transfers. Basically, balance on goods and
services, income and transfers are recorded in current account. Current account balance in
BOP data is recorded in line 1 according to the IMF classification. Current account can be
categorized as followings:
Line 4: Balance on Goods: Referred to as trade balance: exports – imports
Service Balance: For those countries having large service sectors like USA and Japan,
merchandise trade balance is not the most important. For these countries services sector
constitute a significant portion of BOP.
Selling services to foreigners entered as Credits
Purchasing services from abroad entered as Debits
Services are sometimes referred to as Invisible Trade.
Line 7: Balance on Goods and Services
Income Balance:
Investment Income: flow of earnings from direct and portfolio investments,
entered as credit.
Compensation of employees: wages, salaries, other benefits, entered as debit.
Balance on Goods, Services and Income:
Trade Balance – Service balance – Income Balance
Balance on Current Transfer
Including sums sent home migrants, permanent workers abroad (professors, business
executives), parental payments to students abroad, research grants, etc….
Balance on Current Account - Group A
Trade Balance – Services Balance – Income balance – Transfer Balance
Capital Account - Group B
It measures capital transfers and the acquisition or disposal of non-produced and non-financial
Capital transfers  transfer of ownership of fixed assets, transfer of funds, the cancellation of
liabilities by creditors. It also includes both governmental and private debts.
Non-produced and non-financial assets  intangibles like patented entities, leases,
transferable contracts, and goodwill.
Financial Account - Group C
It provides data on long term financial flows such as foreign direct investments, portfolio
investments, and other long term capital movements.
Direct investments abroad  (-)
Foreign Direct Investment  (+)
Portfolio and other investments  purchases and sales of equity and debt securities, changes
in trade credit, loans, currency, and deposits.
Group A + Group B + Group C = Basic Balance
Net Errors and Omissions - Group D
It reflects the transactions that are known to have occurred but for which no specific measure
was made. They are recorded to prevent imbalances in BOP. Ex. Drugs, narcotics in imports,
Total, Groups A through D
Also called the overall balance, or the official settlements balance. It is the net result of
trading, capital and financial activities. It is the sum of all autonomous transactions that must
be financed by the use of official reserves or other non-reserve official transactions.
Reserves and Related Items - Group E
The net result of the overall balance must be financed by the changes in official monetary
The sum of changes in reserves on line 39 is identical to the total change in foreign exchange
reserve position reported on line 38.
1.2 Approaches in Balancing BOP
The basic aim of countries is to arrive at a zero balance in their BOP. But having a zero
balance in BOP is almost impossible for countries. It is not so easy to balance foreign-based
expenditures with foreign-based receipts. Imbalances in BOP will affect the whole economy
of countries and their relationships with the world.
There are various policies that countries may follow in case of imbalances (surpluses or
deficits) in BOP. If there are temporary deficits in BOP, these deficits could be financed by
reserves or to apply a repairing policy. But if deficits are chronic or continuous, then
financing through reserves might not be possible; because the international reserves of
countries are not unlimited. One of the ways to put a pressure on BOP deficits is to limit
foreign trade and exchange rate transactions through custom tariffs, quotas, and limiting
foreign exchange transactions. The aim in this case is to narrow import volume and to
prevent capital outflows. However, this strategy even does not stop deficits but put a pressure
on these deficits. And this type of strategies is against liberalization trends and policies in a
globalized world. And it is against the policies of World Trade Organization (WTO) and IMF.
So there are some other alternatives repairing policies to be applied during BOP Imbalances:
1.2.1 Exchange Rate Adjustments and Elasticity Approach
Exchange rate determination takes place through supply and demand forces of free markets in
floating exchange rate systems. There is little or no government intervention in markets to
rule the rates. When there is a deficit in BOP, then excess supply of domestic currency will
appear in the markets and exchange rates will tend to increase (domestic currencies
depreciate). Then foreign goods and services will be more expensive and import volume will
tend to decrease. And exports will tend to increase since domestic production will be cheaper
in foreign markets. And foreign exchange receipts will increase. This mechanism will work
until there is equilibrium in the market. In case of a surplus in BOP, then the mechanism will
work in reverse direction. This mechanism is most commonly related with current account
balance of BOP.
There is no application with pure floating system in real life in which there is no government
intervention. So some countries have adopted fixed exchange rate system and/or fixed and
free floating system combinely in which they peg their currencies to a single foreign currency
or a basket of foreign currencies (SDR or others). Since the governments of these countries
allow a limited floating around other currencies, this system is commonly known as
“managed float system” (like in Turkey). Again exchange rate adjustment is one of the
important tools to be applied by those countries. When there is a deficit in BOP, the monetary
authorities will tend to devalue their currency against foreign currencies. Consequently,
exports will tend to increase and imports will tend to decrease in those countries.
Elasticity Approach
BOP effects of exchange rate fluctuations are generally explained by Elasticity Approach.
When there is a devaluation (in fixed rate systems) or depreciation (in floating rate systems)
in domestic currency, then exports are likely to increase and imports are likely to decrease.
The positive effects of devaluation depends on price elasticity of export demand. The higher
the price elasticity of foreign demand for exports and domestic demand for imports, the more
the effects of devaluation will be. This theoretical relationship was previously explained by
Marshall-Lerner by the following formula:
Ex + Em  1
Where Ex represents the foreign demand elasticity for exported goods/services and Em
represents domestic demand elasticity for imported goods/services. According to this
approach, in the case of lower elasticities for exported and imported goods/services
devaluation will not be effective. It may even affect BOP negatively. However, the new
studies have shown that these elasticity coefficients are enough high to have the positive
effects of devaluation.
3.2 National Income Approach
National income balance can be represented by the following Keynesian equation:
Y = C + I + G + (X – M)
So when there is an increase in consumption (C), investment (I), government expenditures (G)
and net exports (exports – imports), national income will increase. Governments usually
consider I and G at national level and as a national policy to affect national income. Another
important assumption of the Keynesian theory is that M depends on Y. When Y increases, M
will also increase. This positive relationship between Y and M is named as import function:
M = m (Y) where m is marginal propensity to import.
The first policy to be adopted is related with fiscal policy. For example, when there is a deficit
in BOP, by fiscal policy, government will tend to reduce the expenditure side of the equation,
taxes will tend to increase, and Y will decrease so that M will also decrease. Consequently,
net exports will also be decreasing.
The second type of policy to be adopted is related with monetary policy. In case of a deficit in
BOP, government will apply a restrictive monetary policy to reduce money supply and
increase interest rates so to reduce I, Y and M. However, monetary policy is commonly
related with not trade balance of BOP but with capital account balance of BOP. An important
disadvantage of restrictive fiscal and monetary policies is unemployment problem. When Y
decreases, this will speed up unemployment.
3.3 Foreign Trade Balance and Total Consumption (Absorption) Approach
Absorption approach is adopted version of national income model into foreign economic
relationships. The most important contribution of this approach is that of explaining foreign
trade according to the general working of the economy. When there is a deficit in BOP, then
total expenditures of the country exceeds its production capacity according to this approach,
meaning it produces less than it consumes.
Y = C + I + G + (X-M)
We can re-write the above equation as below:
Y = A + (X-M)
where A means total domestic expenditures and
So, if Y > A, then total domestic production will be greater than total domestic expenditures
and this excess production will be exported to outside and will be a surplus in foreign trade
balance. If Y < A, then there will be a deficit in foreign trade balance. As a result, if Y
increases, the difference between Y and A will be decreased and foreign trade balance will be
On the other hand, when economy is underemployed and Y rises, A will also be rising but if
Y > A (and MPS is positive), then devaluation will be beneficial. When economy is fully
employed, then devaluation will not be beneficial, there is no idle capacity in the economy
and excess demand will be partially met by import and prices will tend to increase. If
devaluation is applied in a full employed economy, inflation will further rise.
3.4 Monetary Approach For Foreign Balance
Elasticity and absorption approaches consider only foreign trade in foreign balancing
disregarding capital movements. There have been important developments in financial
markets and international capital movements in our new world. In order to consider the effects
of capital movements on foreign balancing, monetary approach has been developed in 1970s.
Monetary approach relates deficits/surpluses in BOP into monetary imbalances. Monetary
imbalances occur because of the differences in the money to be kept by public and money
supplied by central bank. If money supply is greater than demand for money, public will use
this excess in domestic and foreign expenditures. But if money supply is less than the demand
for money, then this deficit will be compensated by foreign monetary flows.
Among the critical assumptions of the theory is that demand for money in every economy is
the real demand derived by some factors. One of these factors is the income level of people.
There is a direct relationship between real income and real demand for money. The second
type of factor is that demand for money depends on interest rates among which there is an
indirect relationship. Because when interest rates increase, savings will increase and this will
reduce the demand for money.
Real Demand for money: Md / P
So the relationship between the demand for money and income and interest rates is:
Md / P = f (y, i)
Although demand for money is due to the public, money supply is determined by the central
Money supply is: MS = A ( D + R)
Where A is the money multiplier, D is the emission made by the central bank for internal
economic and financial purposes, and R is the domestic currency driven to the market by the
use of foreign reserves. (D+R) is the monetary base of the country.
When international reserves increase, then (to prevent appreciation of domestic currency) the
more domestic currency will be driven to the market. If international reserves decrease, then
(to prevent depreciation), the domestic currency will be drawn from the market. In fixed
exchange rate systems, this mechanism gains more importance since the central bank
intervenes into the market to stabilize the economy. However, in floating rate systems, there is
no need for intervention and R loses its importance.
Let’s assume that D is driven to the market by the central bank at the beginning so that
demand for money is still constant. What will happen?
Money supply increases
Consumption and investment-savings increase
Part of the investment goes to the foreign portfolios
There will be an outflow in capital account of balance of payments (BOP)
So, an increase in MS will damage BOP.
An increase in MS will have a negative effect on trade and capital balance of BOP,
there will be a deficit.
In fixed rate systems, the domestic currency tends to depreciate. To prevent this, the central
bank will buy domestic currency by selling foreign currency into the market, so R and by
multiplier effect MS will decrease. When money supply decreases, it will not be enough to
meet the demand for money. The difference, this time, will be tried to be compensated by
export revenues. So foreign exchange inflows will be fasten and deficit will be compensated.
4.1 Exchange Rate Impacts
Current Account Balance + Capital Account Balance + Financial Account Balance + Reserves
Balance = BOP
The effect of an imbalance in BOP works differently whether the country has fixed, floating
or managed exchange rates.
4.1.1 Fixed Exchange Rate Countries
The government bears to assure a BOP (the sum of current, capital and financial accounts)
near zero. Otherwise it will intervene in the foreign exchange market by buying or selling
official foreign exchange reserves.
If BOP > 0, then a surplus demand for domestic currency will occur, and exchange rate 
(domestic currency depreciates) and to preserve fixed rate system government will intervene
and sell domestic currency (so that domestic currency will appreciate, and exports , and
imports ) to bring BOP back to zero.
IF BOP < 0, excess supply of the currency will occur, the government will intervene and buy
domestic currency with its reserves of foreign currencies or gold.
If foreign exchange reserves , then government cannot intervene and will have to make
4.1.2 Floating Exchange Rate Countries
The government has no responsibility to peg the foreign exchange rate. The fact that the
current and capital account balance do not sum to zero will automatically alter the exchange
rate in the direction necessary to obtain a BOP near zero.
A country running a current account deficit, with a financial account balance of zero, will
have a net BOP deficit. An excess supply of domestic currency will appear in world markets.
Then domestic currency will fall in value (depreciation), BOP will move back to zero.
4.1.3 Managed Floats
Countries operating with managed floats take actions to maintain their desired exchange rate
values. They alter the market's valuation of a specific exchange rate rather than through
intervention in the foreign exchange markets.
They primarily change relative interest rates to influence the economic fundamentals of
exchange rate determination.
The aim is to attempt to alter the financial account balance, especially short-term portfolios, to
restore an imbalance caused by deficit in current account.
A country may wish to increase domestic interest rates to attract additional capital or
investments from abroad.
Business managers use BOP trends to make forecasting in government policies on domestic
interest rates.
Ex. In those countries having a deficit in current account, investors may expect interest rates
to increase.
4.2 Economic Development Impacts
BOP is also used for economic development analysis. A deficit or surplus is not good or bad
for a country.
From a national income viewpoint,
When a deficit occurs in current account  then bad effect on GDP and employment if
underemployment exists, whereas a surplus have a positive effect.
When deficit  GDP , emp , unemp.
When surplus  GDP, emp. , unemp. 
Under full employment, a current account deficit that can be financed by abroad would also
allow imports of investment goods to .
From a program viewpoint,
Economic development  requires net imports of goods and services which means a deficit
in current account () financed by foreign savings.
From a liquidity viewpoint,
Deficit  a country is being a net long-term creditor of the rest of the world through direct
foreign investments and long term loans.
Ex. Needing foreign loans to close deficits.
We have to describe firstly "parity conditions" in order to answer the following questions:
Are changes in exchange rates predictable?
How are exchange rates related to interest rates?
How does inflation affect exchange rates?
What is the proper exchange rate? And etc...
5.1 Parity Conditions
International Monetary System (IMS) is currently characterized by a mix of freely floating,
managed floating and fixed floating exchanges. No single theory is available to forecast
exchange rates under all conditions.
Parity conditions are certain basic economic relationships, which help to explain exchange
rate movements.
Parity conditions are very important out of the consideration of the reasons behind
exchange rate movements.
Parity conditions well explain the relations among exchange rate movements, inflation,
and interest rates.
So in order to make a forecast about future rates, we have to understand parity conditions
5.2 Prices and Exchange Rates
If the identical product or service can be sold in two different markets, and no restrictions
(tariffs) exist on the sale or transportation costs, the product's price should be the same in
both markets. This concept is called the law of one price.
A primary principle of competitive markets ==> to equalize prices across markets if no
restrictions on the sales and costs
If two markets are two different countries, the product's price may be stated in different
currency terms, but the price of the product should remain the same.
P¥ = P$ × S
P¥ = price of the product in Japan (Japanese Yen)
P$ = price of the product in USA (US $)
S = spot exchange rate
if no higher price (or inflation) in one of the countries
5.3 Purchasing Power Parity and the Law of One Price
PPP is an applied version of the law of one price theory, saying that any good would
be priced the same in different markets or in different countries in all over the world, if
there were no tariffs, restrictions on sales and costs.
This theory was firstly stated by a Swedish, Gustav Cassel in 1918.
He explained this theory after World War I to create the framework of new official
exchange rates while returning back to Gold Standard again.
When rates were imbalanced in later periods in the fixed rate system, it was used also
by the central banks to create the balanced rates.
We can use the same formulation of P¥ = P$ × S to find PPP between two currency.
The PPP exchange rate between two currencies could be stated by:
PI $
where PIY is the price index in Japan
PI$ is the price index in USA in their local currencies
Ex. Identical basket of goods:
S = Y1000 / $10 = Y100/$
In Japan = Y1000
In USA = $10
This is the absolute version of the theory of PPP, stating that the spot exchange rate is
determined by the relative prices of similar basket of goods.
PPP can be considered in two forms:
1. Absolute PPP
States that spot exchange rate is determined by the relative prices of similar baskets of
goods. Like in the example above. Py = S . P$
2. Relative PPP
 More general idea than absolute PPP
 Exchange rates between two currencies will change so that it will reflect
inflationary effects.
 So PPP regards inflationary effects.
 We can formulate this theory as:
E1  E0
 Pd  Pf
E0 = exchange rate in the base year
E1 = exchange rate after the base year
Pd = inflation rate in domestic country
Pf = inflation rate in foreign country
For example, if inflation in Turkey is 50%, and in USA 10%, then we expect TL to depreciate
against $ by 40% to equlalize the price of any good in both countries.
Relating exchange rate movements to rates of inflation, we do not deal with the real values of
E, Pd, and Pf, but deals with their percentage change.
Exhibit 5.2  r in Japan is 4% lower than USA, then Yen must appreciate by 4%. US $ will
be depreciated or devalued.
See Halil Seyidoglu’s example ……..
If r in Turkey is 30% higher than USA, $ will appreciate by 30% against TL.
Point A is equilibrium point, in Point B; r in Turkey is 30% higher than r in USA, but $
appreciated only 20%. This is disequilibrium point.
Empirical Tests of PPP
Extensive tests have been done for the validity of PPP. Most of them did not prove PPP.
PPP was not accurate in predicting future exchange rates
Goods/services do not in reality move at zero cost between countries
In fact, many goods are not tradable. ie. Haircuts
Many goods are not the same quality across countries.
Two General conclusions have been made from these tests:
1. PPP may hold up over the very long run but poorly for shorter time periods
2. Theory holds better for countries relatively with high rates of inflation and
underdeveloped capital markets.
But several problems exist with these tests:
1. Most of the tests  used price indexes of traded goods, however there are many nontraded goods like housing and medical costs which affect traded goods and economic life.
2. It is difficult to find identical markets among countries because of taste differences, level
of developments, level of incomes, etc.. PPP should be considered in identical markets.
3. PPP requires knowledge of what the market is forecasting for inflation differentials but
the data that are available are either historical inflation rates or existing differential
interest rates.
4. Time periods for testing have seldom been free of at least some government interference
in the trade process. Because it requires no government interference to have identical
market baskets.
Exchange Rate Indices: Real and Nominal
Exchange rate indices are used for evaluating an individual currency against other currencies
to determine relative PP, whether it is “Overvalued” or “Undervalued” in terms of PPP.
 Nominal exchange rates are current rates in the selected period, including
inflationary effects.
 Real exchange rates are rates calculated according to a base period, which are
excluded from inflationary effects.
 On the other hands, nominal effective exchange rate index calculates, on a weighted
average basis, the value of the subject currency at different points in time, according to
trade with the country’s major trading partners. It does not indicate true value of the
 Real effective exchange rate index indicates how the weighted average PP of the
currency has change relative to selected base period.
Exhibit 5.3: IMF index published frequently.
Index is calculated for a base year of 1990=100
If changes in exchange rates just offset differential inflation, real effective excgange
rate = 100
If exchange rates strengthen more than differential inflation, then index >100 and
subject currency would be considered “Overvalued”.
Index < 100, then Undervalued.
A country’s real effective exchange rate index is an important tool for predicting upward or
downward pressure on its BOP and exchange rate.
Exchange Rate Pass – Through
Incomplete exchange rate pass-through is one reason that a country’s real effective exchange
rate index can deviate for lengthy periods from its PPP equilibrium level of 100.
The degree to which the prices of imported and exported goods change as a result of exchange
rate changes is termed Pass – Through, which is the measure of response of imported and
exported product prices to exchange rate changes.
Assume that BMW produces automobile in Germany; when exporting the auto to USA, the
price of BMW in USA should be;
If DM appreciates 10% against $, P$BMW proportionally is expected to increase 10%. If it
increases by the same %, then exchange rate pass-through is said to be Complete (100%).
However, if P$BMW rises by less than % in S, then the pass-through is Partial.
PDMBMW = DM59,500
S1 = DM1.70/$
P$BMW = $35,000
If DM appreciate 20%, S2 = DM1.4167/$, then P$BMW theoretically should be $41,999
(DM59,500  DM1.4167). But P$BMW is only $40,000.
Then the degree of Pass-Through is only partial. P$BMW rose only 14.29% while SDM/$
decreased by 20%.
Degree of pass through = 14.29%  20.00% = 0.71 = 71%
The remaining 5.71% (20.00 – 14.29) of the exchange rate change has been absorbed
by BMW.
The concept of price elasticity of demand is useful when determining the desired level of Pass
EP 
% inQD
% in P
When BMW is Price Inelastic, meaning that QdBMW is relatively unresponsive to Price
Changes, may often demonstrate a high degree of pass-thorugh. When P , then little effect
on Q, so TR will .
When BMW is Price Elastic, then effects will be on opposite direction. If S DM/$ and P$DM
increase by 10%, then US consumers would reduce the number of BMWs purchased so TR
will .
Interest Rates And Exchange Rates
Considering how interest rates are linked to exchange rates!!
The Fisher Effect
Named after Irving Fisher, stating that nominal interest rates in each country are equal to the
required rate of return plus compensation for expected inflation.
i = nominal interest rates,
r = real interest rates,
 = expected rate of inflation
Forecasting future is difficult because of . Empirical tests have shown that Fisher
Effect exists for short maturity government securities like treasury bills and notes.
In LR, there are fluctuations and financial risk.
International Fisher Effect
It sets relation between % in S and differential interest rates.
S1  S 2
 100  i$  i
Fisher open states that % in spot rates should be equal to interest rate
$ based investor buys a 10-year Yen bond earning 4%, compared with 6% interest
available on $.
Investor expects Yen to appreciate against $ by at least 2% per year during 10 years.
If not, $ based investor will be better off.
If Yen appreciates by 3% during 10 years, $ based investor would earn 1% higher return
of bonus.
Interest Rate Parity (IRP)
IRP provides a linkage between foreign exchange markets and international money markets.
IRP is in the result of arbitrage possibilities among international money and foreign exchange
markets. Funds will move from low rate countries to higher rate countries. When borrowing,
investors prefer lower interest rates, when investing, they prefer higher rates of interest.
Assume an investor has $1,000,000 to invest and two alternatives to follow:
1. $ based investment on securities
2. SF based investment on securities
They have identical risk and maturity. Parity condition for these alternatives;
1  i$   S SF / $  1  i SF  
SF / $
= 1  0.02   1.4800  1  0.01 
Ignoring transaction costs, if both sides are equal to each other, S and F rates are
considered to be at IRP.
Any difference in interest rates must be offset by the difference between S and F.
F 1  iSF 
SF1.4655 / $ 1.01
 0.99  1.00
1  i$  SF1.4800 / $ 1.02
In order to avoid risk, forward rates are agreed today.
There is no profit among $ and SF investments. We can simplify the above formula as;
i$  iSF 
F S
When i$  iSF 
F S
, then funds will move from USA to Switzerland, otherwise to USA.
i$ = 10%
0.70  0.10 
iTL = 70%
S = 1$: 430,000 TL
F  430 ,000
430 ,000
F = 1$: 688,000 TL
If F = 1$: 550,000 TL, then;
0.70  0.10 
550 ,000  430 ,000
 0.60  0.28
430 ,000
This time, funds will move from USA to Turkey. There will be arbitraging profit called
Covered Interest Arbitrage (CIA).
For example,
1. Purchase of Yen in the spot market and sale of Yen in the forward market narrows the
premium on the forward Yen. The spot yen strengthens from the extra demand and the
forward Yen weakens because of extra sales. A narrower premium on the forward Yen
reduces the foreign exchange gains previously captured by investing in Yen.
2. The demand for Yen denominated securities causes Yen interest rates to fall, while the
higher level of borrowing in the US causes $ interest rates to rise. The net result is a
wider interest differential in favor of investing in the $.
CIA continues until IRP is established again.
P.125, Exhibit 3.9, 3.10 and 3.11 (Eiteman, 2001)
Profit on $: $1,040,000
i$  i 
Profit on Yen: $1,044,638
106.0 - 103.5
 8% - 4% 
 4%  2.4%
103 .5
Funds will flow from USA ($) toward Japan (Yen) until IRP is established.
The net result of the disequilibrium is that fund flows will narrow the gap in interest rates
and/or decrease the premium on the forward Yen.
The interest rate parity line (p.126) shows the equilibrium state, but transaction costs cause
the line to be a band rather than a thin line.
Transaction costs arise from foreign exchange and investment brokerage costs on buying and
selling securities. Typical transaction costs in recent years have been in the range of 0.18% to
0.25% on an annual basis.
Point X shows one possible equilibrium position where a –4% interest differential on Yen
securities would be offset by a 4% premium on the forward Yen. Point U is the disequilibrium
position where Yen premium is 4.83%.
Y 106.00 / $  Y 103.50 / $ 360 days
 100  4.83%
Y 103.50 / $
180 days
Calculation of Forward Rates at IRP:
 
n 
1   iY  360  
Fn  Y / $   
n 
 
1   i$  360  
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