Theories of Exchange Rate

Theories of Foreign
Exchange Rate Movement

and International Parity
Conditions
Mishu Agarwal
Lecturer- AKGIM
Introduction
 The phenomenon of exchange rates
movement is an important issue in
international finance and managers of
multinational firms, international investors,
importers and exporters and government
officials attach enormous importance to it.
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 inflation-

exchange 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 Purchasing Power
Parity
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.
Reasons of Deviations from PPP
 Transaction Costs
– The Interest rate available to an arbitrageur
for borrowing may exceeds the rate he can
lend at
 Capital Controls
– Governments sometimes restrict import and
export of money through taxes or outright
bans.
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. This form
of PPP theory accounts for market imperfections such as
transportation costs, tariffs and quotas. Relative PPP theory
accepts that because of market imperfections prices of similar
products in different countries will not necessarily be the same
when measured in a common currency.
Graphic Analysis of PPP
Purchasing Power Parity theory which helps us to
assess the potential impact of inflation on exchange
rates. The vertical axis measures the percentage
appreciation or depreciation of the foreign currency
relative to the home currency while the horizontal
axis measures the percentage by which the inflation
in the foreign country is higher or lower relative to
the home country.
Empirical Testing of PPP
Theory
Substantial empirical research has been done to
test the validity of PPP theory. The general
conclusions of most of these tests have been
that PPP does not accurately predict future
exchange rates and that there are significant
deviations from PPP persisting for lengthy
periods.
International Fisher Effect
(IFE)
 The IFE uses interest rates rather than inflation rate
differential to explain the changes in exchange rates
over time. IFE is closely related to the PPP because
interest rates are significantly correlated with
inflation rates. The relationship between the
percentage change in the spot exchange rate over time
and the differential between comparable interest rates
in different national capital markets is known as the
‘International Fisher Effect.’
 The IFE suggests that given two countries, the
currency in the country with the higher interest rate
will depreciate by the amount of the interest rate
differential.
Theory Key Variables of Theory Summary of Theory
Interest rate party Forward rate Interest differential The forward rate of one currency with
(IRP) premium (or respect to another will contain a premium
discount) (or discount) that is determined by the
differential in interest rates between the two
countries. As a result, covered interest
arbitrage will provide a return that is no
higher than a domestic return.
Purchasing Power Percentage change Inflation rate The spot rate of one currency with respect to
Parity (PPP) in spot exchange differential another will change in reaction to the
rate differential in inflation rates between the two
countries. Consequently, the purchasing
power for consumers when purchasing goods
in their own country will be similar to their
purchasing power when importing goods
from the foreign country.
International Fisher Percentage change Interest rate differential The spot rate of one currency with respect to
Effect (IFE) in spot exchange another will change in accordance with the
rate differential in interest rates between the two
countries. Consequently, the return on
uncovered foreign money market securities
will, on an average, be no higher than the
return on domestic money market securities
from the perspective of investors in the home
country.

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Theories of Foreign

Exchange Rate Movement

The PPP theory focuses on the inflation-

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