Theories of Exchange Rate. Introduction An exchange rate is the relative price of one currency in terms of another. It influences allocation of resources.

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Presentation transcript:

Theories of Exchange Rate

Introduction An exchange rate is the relative price of one currency in terms of another. It influences allocation of resources within and across countries.

Introduction Exchange rates are affected by many factors. For instance, Balance of payments, inflation, interest rates, money supply, political factors, market sentiments, technical factors etc. Important ones are Price and Interest rates

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 form of PPP & Relative form of PPP

Absolute Purchasing Power Parity(PPP) 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. (The Law of One price)

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.

Interest Rate Parity (IRP) A forward exchange rate is the rate that is currently paid for the delivery of a currency at some future date. It has the spot rate as its base, plus the interest factor. The interest factor which is factored into the rate is called the interest rate parity.

International Fisher Effect (IFE) The FE theory suggests that foreign currencies with relatively high interest rates will depreciate because the high nominal interest rates reflect expected inflation.

Which factors affect Exchange rates? Which factor is the main? What is the difference between absolute and relative PPP? What is the meaning of The Low of One Price?

Thank you for attention !