Economic Theories of Exchange Rate

Determination

(Part II – Module VII)

Dr Arpita Shrivastava
What determines Exchange rate??
• Exchange rates can be either fixed or floating.
Fixed exchange rates use a standard, such as gold or another precious
metal, and each unit of currency corresponds to a fixed quantity of that standard
(doesn’t exits today). For example, in 1968 the U.S. Treasury determined that it
would buy and sell one ounce of gold at a cost of $35

Current international exchange rates are determined by a managed floating

exchange rate. A managed floating exchange rate means that each currency’s value
is affected by the economic actions of its government or central bank.
 1. Theory of Demand and supply
• Determined by the demand and supply of currency at world market.
For example, If the demand for dollar outstrips the supply of the them and if the supply of Japanese yen is
greater than the demand for them, the dollar yen exchange rate will change. The dollar will appreciates against
the yen (or can be called as yen will depreciates against dollar)

The rate of exchange is said to be equilibrium

when demand for some currency in terms of
other currency is equal to its supply
Sources of demand for Forex
• Purchase of foreign goods by domestic residents ( i.e. imports)
• Payments of international loans
• Gifts and grants to rest of the world
• Investments in rest of the world.
Sources of Supply
• Purchase of domestic goods by foreigner ( i.e. exports)
• FDI
• Speculative purchases
• Tourism and remittance abroad.
• Transfer of foreign exchange by residents of country abroad
Nothing is fixed , it can not reveal…
1. What are the exact factors?
2. When the demand supply change?
3. Under what conditions demand and supply of currency is
calculated?
To get this better understanding, economist suggested few theories of
exchange rate determination:

o Purchasing Power Parity

- Absolute PPP
- Relative PPP
o Interest Rate Parity Theory
 What is PPP?
• Purchasing Power Parity is an economic theory that allows comparison of
the purchasing power of the various world currencies to one another.

• Oldest theory, Developed by Gustav Cassel in 1918

• It is a theoretical exchange rate that allows you to

buy the same amount of goods and services in
every country.

This theory states that, in ideally efficient markets, identical goods

should have only one price. The law of one Price (LOOP)
Purchasing Power Parity (PPP)
• Based on THE LAW OF ONE PRICE……

$5 $5
What is LOOP
The law of one price states that, in the absence of trade frictions and conditions of free
competition and price flexibility all identical goods whatever be the market must have only
one price if they are using a common currency.
- It assumes that there would be no tariff, taxes, quotas..etc ( a limitation to the theory)

- Not relate to immobile goods such as land, house, buildings etc.

Suppose, the one USD is equal to 70 INR. If a Toy sells for $15 in United states while in India
they sell it for 700 rupees.
Since 1 USD = 70 INR, the toy which cost $15 in US costs only $10 in India (700/70) if we buy it
from India.

Clearly, there is an advantage of buying the toy in India as customers would be at gain.
Continue with the given example if the consumers will decide to do
this. We should expect to see these three things:

1. American consumers demand for Indian rupees would increase

which will cause Indian rupees to become more expensive.
2. The demand for toy sold in US market would decrease and hence its
prices would tend to decrease.
3. The increase demand for toy in India would make them more
expensive.

Thus the prices in US and India would start moving towards an equilibrium.
PPP theory states that….
• Currencies are used to purchased goods and services.
• Value of currencies depends upon the quantity of goods and services
that can be purchased by the currencies.
• Thus, value of money is the purchasing power.
• Exchange rate can also be calculated on the basis of purchasing power
• Exchange rate is the expression of one currency in terms of another
currency ( for eg, 1USD =60 INR)
Types of PPP
1. Absolute PPP: It postulates that the equilibrium exchange rate
between currencies of two countries is equal to the ratio of the
price levels of two nations.
Therefore the price of a product in country X and the price of the
product in country Y (in Y’s currency) should be such that, the ratio of
the prices is the exchange rate between the currencies of the two
countries.
Illustration 1
Suppose a particular basket of goods in India cost rs 7000/- and $100 in
USA. That means the exchange rate would be:

7000/100 = 70/1

1 USD = 70 INR
2. Relative PPP theory
• Purchasing power of currency changes due to inflation and deflation
• When there is an inflation, price level increases, quantity of goods that can
be purchased by one unit of currency, declines. Thus the purchasing power
also declines and vice versa.
• Thus, inflation/deflation affect the exchange rate.

“The relative purchasing power parity theory is an economic theory which

predicts the relationship between inflation rates of two countries over a
specified period of time and the movement in the exchange rate between
the two currencies over the same period”.
Relative PPP is the dynamic version of Absolute PPP
- The difference in the rate of change in prices at the home and abroad
is the difference in the inflation rates - is equal to the percentage of
depreciation or appreciation of the exchange rate.

For example, if India has a inflation rate of 5% and the US has an

inflation rate of 3%, this means the INR will depreciate against dollar by
2% every year.
Illustration 2
Suppose, Prices are expected to rise in Japan by 10% in coming year. And If US want to trade with them then
They should plan currency in such a manner that it will give the same amount of yen in next year.
- so, to keep purchasing power unchanged, USD should rise by 10% against Japanese yen by next year. (if we
want to keep the same basket)
- Now, Expected rate of exchange for next year, E (Si), should be equal to So x (1+ 0.10)

Now, suppose if inflation in US is also expect to increase by 7% in coming year.

So, relative to USA, the prices in Japan will only be rising by 3%

Expected Spot rate = So * [ 1+ (Inflation of FC – Inflation of HC]

So expected exchange rate in this case would be : E (Si) = So x (1+ 0.03)

If spot exchange rate of Japan now is So = 120 JYP (against dollar). Then next year’s expected rate of
exchange would be

E (Si) = 120 (1+0.03)

Yen 123.6 = 1 USD
Problem 1
Suppose the Canadian spot exchange rate is 1.18 Canadian Dollars per
US dollar. US inflation rate is expected to be 3% per year, and Canadian
inflation is expected to be 2%.
Do you expect US dollar to appreciate or depreciate relative to
Canadian Dollar?

Expected Spot rate = So * [ 1+ (Inflation of FC – Inflation of HC]

Expected spot rate in 1 year = 1.18 * [ 1+ (0.02-0.03)]

Esi = 1.17 Canadian dollar per $
Usefulness of PPP
• Develop reasonable accurate economic statistics to compare the
market conditions of different countries

• Compare quality and standard of living in different countries which

may not be possible if we look only to per capita income.
Nominal GDP

PPP GDP

Source : World Bank and IMF 2019

https://www.businesstoday.in/current/economy-politics/india-remains-3rd-largest-economy-in-
purchasing-power-parity-still-way-behind-china-
us/story/407776.html#:~:text=India%20accounts%20for%206.7%20per,States%2C%20World%20Bank
%20data%20for
Limitations of PPP
1. It ignores many real determinants
2. Based on unrealistic assumption
3. The theory assumes that the change in price levels could only
bring change in exchange rates and vice versa
4. The government regularly intervene in trade between countries
5. It disregards the basis of international trade
Interest Rate Parity Theory (IRP)
• IRP is a theory in which the interest rate deferential between two
countries is equal to the differential between forward exchange rate
and spot exchange rate.
• Forward exchange rates for currencies are exchange rates at a future
point in time, as opposed to spot exchange rates, which are current
rates.
• It plays a crucial rate in Forex markets.
• The interest rate parity presents an idea that there is no arbitrage in
the foreign exchange markets.
The exchange rate Purely depend upon the
between two interest rates prevailing in
currencies the two respective countries
Formula for IRP

• Borrowed amount = $100000

• Interest rate prevailing in India = 12%
• Interest rate prevailing in USA = 7%
• Anyone want to take advantage of the
situation
Where; • Try borrowing from US @7% and invest
Fo = Forward Rate it to India by extending load at 12%
So = Spot rate
Ic = Interest rate for country C • Thereby earning 5% differential interest.
Ib = Interest rate for county b

Is this Possible??
No….Not even possible !!!
Lets extend the above example –
Assume , spot rate is $1 = 64 rs
Hypothetically, Resulting gain = $100000*64*5% = 3,20,000

Lets find out the one year forward rate,

Fo = 64 * (1+ 0.12)/ (1+ 0.07)

Fo = 66.99 or 67
 Amount Borrowed Interest @7% $100000
Interest @7% $7000
Total $107000

Amount Payable as per spot rate at the beginning of the year 68,48,000 rupees
($107000 * 64)

Amount Payable as per expected rate at the end of the year 71,69,000 rupees
($107000 * 66.99 Rs)

As per the interest rate parity theory the resulting exchange loss has been
completely off set the gain made through interest rate differential

Resulting gain = $100000*64*5% = 3,20,000 Excess payable because of the change exchange rate is =
71,69,000 – 68,74,000 = 3,20,000 (approx.)
IRP theory states that
• The exchange rate between rupees and dollars would have changed adversely in such a way that
the interest rate differential so earned that it shall compensate the exchange loss arising on
repayment of the US loan
• The currency with higher interest rate will suffer depreciation while currency with lower interest
rate will appreciate
• In an efficient money and capital market in existence within the two countries, the exchange rates
will adjust in such a way that it will bring the parity in the interest rate, and in turn remove the
possibility of any arbitrage opportunity
• Arbitrage is not possible
• Using the interest rate parity can have many advantages because it can be used to predict the
forward exchange rate of currencies, can be used to represent no-arbitrage state, and can
also be used to describe the relationship between interest rates and exchanges rates of two
countries
Limitation
In many cases, countries with higher interest rate often experience its
currency appreciate due to higher demands and higher yields and has
nothing to do with the risk-free arbitrage.
International Fisher Effect

• link between interest rates and exchange rate movements.

• Irving Fisher, a U.S. economist, developed the theory.
• According to Fisher, changes in inflation do not impact real
interest rates, since the real interest rate is simply the
nominal rate minus inflation.

Real interest rate = nominal interest rate – expected

inflation.

https://corporatefinanceinstitute.com/resources/knowledge/economics/international-fisher-effect-
ife/
Foreign Direct Investment
• FDI refers to the flow of capital between countries.
• The growth of FDI has accompanied the rise of globalization.
• According to the United Nations Conference for Trade and
Development (UNCTAD), FDI is ‘investment made to
acquire lasting interest in enterprises operating outside
of the economy of the investor.’
• The investor has control over the assets invested in
• FDI is undertaken by both private sector firms and governments
Where is FDI made?

Foreign Direct Investments are commonly made in open

economies that have skilled workforce and growth prospect.
FDIs not only bring money with them but also skills,
technology and knowledge.
Benefits of Foreign Direct Investment

Some of the benefits for Some of the benefits for

businesses: the host country:
• Market diversification • Economic stimulation
• Tax incentives • Development of human capital
• Lower labor costs • Increase in employment
• Preferential tariffs • Access to management expertise,
skills, and technology
• Subsidies
Types and Examples of Foreign Direct
Investment

• Horizontal: a business expands its domestic operations to a foreign country. In this

case, the business conducts the same activities but in a foreign country. For example,
McDonald’s opening restaurants in Japan would be considered horizontal FDI.

• Vertical: a business expands into a foreign country by moving to a different level of

the supply chain. In other words, a firm conducts different activities abroad but these
activities are still related to the main business. Using the same example, McDonald’s
could purchase a large-scale farm in Canada to produce meat for their restaurant
FDI in India
During the fiscal ended March 2019, India received the highest-ever FDI inflow of $64.37 billion.
The FDI inflows were $45.14 billion during 2014-15 and $55.55 billion in the following year

https://www.investindia.gov.in/foreign-direct-investment
Test your Understanding
1. Purchasing Power Parity theory is related with
(a) Interest rate
(b) Bank rate
(c) Wage rate
(d) Exchange rate

(d) Exchange rate

An accounting loss or gain that arises from translating the assets and
liabilities of a foreign subsidiary (non-dollar denominated) into the parent
company's currency is accounted for as a translation adjustment
__________.

1. in the owners' equity section

2. on the income statement
3. in both the balance sheet and income statement
4. on internal accounting records only and does not materially impact
accounting income

1. in the owners' equity section

Purchasing-power parity (PPP) refers to__________.
1. the concept that the same goods should sell for the same price across countries after exchange
rates are taken into account
2. the concept that interest rates across countries will eventually be the same
3. the orderly relationship between spot and forward currency exchange rates and the rates of
interest between countries
4. the natural offsetting relationship provided by costs and revenues in similar market environments

1. the concept that the same goods should sell for the same
price across countries after exchange rates are taken into
account
The forward exchange rate __________.
1. is the rate today for exchanging one currency for another for immediate delivery
2. is the rate today for exchanging one currency for another at a specific future date
3. is the rate today for exchanging one currency for another at a specific location on a specific future
date
4. is the rate today for exchanging one currency for another at a specific location for immediate
delivery

2. is the rate today for exchanging one currency for another at

a specific future date
The spot exchange rate __________.

1. the rate today for exchanging one currency for another for immediate delivery
2. is the rate today for exchanging one currency for another at a specific future date
3. is the rate today for exchanging one currency for another at a specific location on a specific future
date
4. is the rate today for exchanging one currency for another at a specific location for immediate
delivery

1. the rate today for exchanging one currency for another for
immediate delivery
Rf (foreign currency’s interest rate) in Japan is 6% p.a., while that
in India is 3% p.a. Spot Rupee Yen is 0.4002 and the twelve
month yen rate is 0.388874. You wish to invest Rs.1,00,000 in
risk free investments for one year. Will you invest the Rs.100,000
in India or convert it into yen and invest in Japan?