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MBA (Finance specialisation) & MBA – Banking and Finance (Trimester) Term VI Module : – International Financial Management Unit II: Foreign Exchange Markets Lesson 2.2 (Theories of Exchange rate )

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Theories of exchange rate determination 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. The three theories of exchange rate determination are: 1. Purchasing Power Parity (PPP), which links spot exchange rates to nations’ price levels. 2. The Interest Rate Parity (IRP), which links spot exchange rates, forward exchange rates and nominal interest rates. 3. The International Fisher Effect (IFE) which links exchange rates to nations’ nominal interest rate levels.

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Purchasing Power Parity A Swedish economist, Gustav Cassel, stated in 1918 that purchasing power of a currency is determined by the amount of goods and services that can be purchased with one unit of that currency. If there are two currencies, it would be fair to say that the exchange rate between these two currencies would be such that it reflects their respective purchasing power. This principle is referred to as Purchasing Power Parity (PPP). If the current exchange rate is such that it does not reflect purchasing power parity, it is a situation of disequilibrium.

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Purchasing Power Parity Let us illustrate this concept with the help of an example. Suppose, at the period zero, a basket of goods and services is costing £100 in the UK and $180 in USA. There is no restriction of buying this basket of goods and services either from the UK or from the USA. Then, it would be correct to conclude that the two amounts paid in respective currencies are equivalent. In other words, £100 = $180 or £I = $1.80

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Purchasing Power Parity Or, we can simply say that the exchange rate at the time zero is $1.80/£. If we use the symbol S 0 to designate this exchange rate, then we write: S 0 = $1.80/£ Say after one year (period 1), the same basket of goods and services costs £103 in the UK market while it costs $186 in the USA market. Again, it is reasonable to say that these two sums are equal. That is, £103=$186 or £1 =$1.8058 or the exchange rate, S1, at the period 1 is: $1.8058/£.

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Purchasing Power Parity By looking at the exchange rate S 0 and S 1, it clear pound sterling slightly appreciated as compared to dollar over the period of one year. The reason for this could be understood from the inflation rate of the two countries In US, rate of inflation = [(186 -180)/180] x 100 = 3.33% In UK, rate of inflation = [(103 -100)/100] x 100 = 3% This shows that the rate of inflation is higher in the US than in the UK. It is inferred, then, that the currency of the country where inflation rate is higher is likely to depreciate in comparison to the currency of the country with lower rate of inflation.

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Purchasing Power Parity Now this illustration can be generalized by taking two countries A and B. At the reference point of time (time zero), the price of the given basket is P A0 in the country A and P B0 be the price of the given basket in country B.Therefore, P A0 = S 0 x P B0 (equation 1) At a later period (time 1), the price changes to PA1 and PB1 respectively. P A1 = S 1 x P B1 (equation 2) The relation between prices at different points of time is linked through the inflation.

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Purchasing Power Parity That is P A1 = P A0 (1 + r A ) (equation 1) At a later period (time 1), the price changes to P A1 and P B1 respectively. P A1 = S 1 x P B1 (equation 2) The relation between prices at different points of time is linked through the inflation.

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Purchasing Power Parity That is, P A1 = P A0 (1 + r A ) (Equation 3) and P B1 = P B0 (1 + r B ) (Equation 4) Where r A and r B are the rates of inflation in the Country A and Country B respectively. From Equation 1 and Equation 2, S 0 = (P A0 / P B0 ) S 1 = (P A1 / P B1 ) Using Equation 3 and Equation 4, we can write: S 1 = [P A0 (1 + r A ) / P B0 (1 + r B )] S 1 = S 0 [(1 + r A ) / (1 + r B )] (equation 5). This equation links the exchange rates with inflation rates in two countries and it is called Purchasing power parity relationship.

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Problems Q1. In India, prices changed from Rs 4500 to Rs 5500 over a period of three years for the same basket of goods whereas they changed from $100 to $110 over the same period in the U.S.A. What initial exchange rate (S 0 )? What is expected exchange rate after 3 years (S 3 )? Q2. Inflation rates in the UK and India are respectively 3% and 6% per annum? What is the expected exchange rate after one year, if it was Rs 78/ £ at the beginning ? Q3. Price indices in the UK and USA are 125 and 200 respectively at the reference period (time zero). These indices change to 129 and 205 after one year. Calculate the exchange rate after one year, given the reference exchange rate of $1.80/ £.

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