Theories of Foreign Exchange Rate Movement and International Parity Conditions

Mishu AgarwalMishu Agarwal

Lecturer- AKGIMLecturer- 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 Reasons of Deviations from PPPPPP

Transaction CostsTransaction Costs– The Interest rate available to an The Interest rate available to an

arbitrageur for borrowing may exceeds arbitrageur for borrowing may exceeds the rate he can lend atthe rate he can lend at

Capital ControlsCapital Controls– Governments sometimes restrict import Governments sometimes restrict import

and export of money through taxes or and export of money through taxes or outright bans.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 (IRP)

Forward rate premium (or discount)

Interest differential The forward rate of one currency with respect to another will contain a premium (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 Parity (PPP)

Percentage change in spot exchange rate

Inflation rate differential

The spot rate of one currency with respect to another will change in reaction to the 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 Effect (IFE)

Percentage change in spot exchange rate

Interest rate differential The spot rate of one currency with respect to another will change in accordance with the 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.