Ahmed
Ahmed
Ahmed
Trade competitiveness:
PPP has implications for trade competitiveness. If a country's currency is overvalued relative to its purchasing power, its
goods and services become relatively more expensive in international markets, potentially reducing its competitiveness.
• Conversely, if a country's currency is undervalued, its goods and services become cheaper for foreign buyers,
enhancing its trade competitiveness.
Arbitrage opportunities:
PPP can create arbitrage opportunities for traders and investors. If prices of identical goods differ between two countries
due to exchange rate deviations from PPP, traders can exploit the price discrepancies by buying low in one country and
selling high in another.
• These arbitrage activities help to narrow the price differentials and contribute to the adjustment of exchange rates
towards PPP.
Factors Hindering Purchasing Power
Parity(PPP)
Trade Barriers and Transportation Costs:
• Trade barriers like tariffs, quotas, and non-tariff barriers hinder the free flow of goods and
services.
• Transportation costs vary and can impact the overall cost of goods, leading to price differentials.
• The international Fisher effect (IFE) theory suggests that currencies with
higher interest rates will depreciate because the higher interest rates reflect
higher expected inflation.
• Hence, investors hoping to capitalize on a higher foreign interest rate
should earn a return no higher than what they would have earned
domestically.
SUMMARY OF IFE
Evaluating the IRP, PPP, and IFE Theories
for Exchange Rate Analysis
Interest Rate Parity Theory (IRP):
• IRP theory suggests that the difference in interest rates between two countries determines
the expected change in exchange rates.
• It states that the interest rate differential should be equal to the expected change in the
exchange rate to prevent arbitrage opportunities.
• The IRP, PPP, and IFE theories offer different perspectives on the
relationship between interest rates, inflation rates, and exchange rates.