Theories of Exchange Rate
Introduction
• An exchange rate is the relative price of one
currency in terms of another.
• It influences allocation of resources within and
across countries.
Introduction
• Exchange rates are affected by many factors.
• For instance, Balance of payments, inflation,
interest rates, money supply, political factors,
market sentiments, technical factors etc.
• Important ones are Price and Interest rates
Theories of Exchange Rate
The three theories of exchange rate determination are• Purchasing Power Parity (PPP), which links spot
exchange rates to nations’ price levels.
• The Interest Rate Parity (IRP), which links spot
exchange rates, forward exchange rates and nominal
interest rates.
• The International Fisher Effect (IFE) which links
exchange rates to nations’ nominal interest rate levels.
Purchasing Power Parity(PPP)
• The PPP theory focuses on the inflationexchange rate relationships. If the law of one
price were true for all goods and services, we
could obtain the theory of PPP. There are two
forms of the PPP theory:
• Absolute form of PPP
&
• Relative form of PPP
Absolute Purchasing Power Parity(PPP)
• The absolute PPP theory postulates that the
equilibrium exchange rate between currencies of
two countries Is equal to the ratio of the price
levels in the two nations. Thus, prices of similar
products of two different countries should be
equal when measured in a common currency as
per the absolute version of PPP theory. (The Law
of One price)
Relative Purchasing Power Parity
• The relative form of PPP theory is an alternative
version which postulates that the change in the
exchange rate over a period of time should be
proportional to the relative change In the price
levels in the two nations over the same time
period.
Interest Rate Parity (IRP)
• A forward exchange rate is the rate that is
currently paid for the delivery of a currency at
some future date.
• It has the spot rate as its base, plus the interest
factor.
• The interest factor which is factored into the rate
is called the interest rate parity.
International Fisher Effect (IFE)
• The FE theory suggests that foreign currencies
with relatively high interest rates will depreciate
because the high nominal interest rates reflect
expected inflation.
• Which factors affect Exchange rates? Which
factor is the main?
• What is the difference between absolute and
relative PPP?
• What is the meaning of The Low of One Price?
Thank you for attention!