EXCHANGE RATE THEORIESTRADITIONAL APPROACH ( ALSO CALLED THE TRADE

OR ELASTICITIES APPROACH) :

• BASED ON FLOW OF GOODS & SERVICES.•ASSUMES AN EQUILIBRIUM EXCHANGE RATE WHERE

THE IMPORTS BALANCES THE EXPORTS OF THE COUNTRY.

•IF AT ANY POINT OF TIME THE IMPORTS EXCEEDS THE EXPORTS (TRADE DEFICIT) THEN THE EXCHANGE RATE

WILL FALL, WHICH IN OTHER WORDS MEANS – THE DOMESTIC CURRENCY WILL DEPRECIATE.

EXCHANGE RATE THEORIESIN SUCH A SITUATION, THE COUNTRIES EXPORTS WILL BE CHEAPER TO FOREIGNERS AND IMPORTS

WILL BE COSTLIER FOR RESIDENTS.

THE RESULT IS THAT THE NATIONS EXPORTS TEND TO RISE AND THE IMPORTS TEND TO FALL TILL THE

BALANCE IN RESTORED.

THE SPEED OF THE ADJUSTMENT WILL DEPEND UPON THE DEGREE OF RESPONSIVENESS OF THE

TRADE TOWARDS CHANGES IN PRICE.

EXCHANGE RATE THEORIESASSUMING A FULL EMPLOYMENT PHASE IN THE

NATION, IT IS ADVISED THAT THE DOMESTIC RESOURCES OF THE NATION BE SHIFTED

TOWARDS PRODUCTION OF EXPORT ORIENTED GOODS AND SERVICES.

EXCHANGE RATE THEORIESPURCHASING POWER PARITY : ONE OF THE MOST

CONTROVERSIAL THEORIES.

BASED ON INFLATION EXCHANGE RATE RELATIONSHIP.

IN ITS ABSOLUTE FORM IT IS ALSO CALLED “LAW OF ONE PRICE”.

EXCHANGE RATE THEORIESTHIS THEORY SUGGESTS THAT THE PRICE OF

SIMILAR PRODUCTS OF TWO DIFFERENT COUNTRIES SHOULD BE EQUAL, IF THEY ARE

MEASURED IN A COMMON CURRENCY.

IF, THERE EXISTS ANY DIFFERENCE THEN THE DEMAND SHOULD SHIFT FROM ONE COUNTRY TO ANOTHER IN SUCH A WAY THAT THE PRICES WILL

HAVE TO CONVERGE.

EXAMPLESUPPOSE, A PRODUCT OF THE SAME QUALITY AND SIZE IS PRODUCED BOTH BY INDIA AND

CHINA. AS PER THE THEORY, IF MEASURED IN A COMMON CURRENCY THE PRICE OF THE

PRODUCT IN INDIA WILL BE EQUAL TO THAT IN CHINA.

IF THE PRICE, IN CHINA, IS LOWER THAN THAT IN INDIA, THEN DEMAND FOR THE PRODUCT WILL INCREASE IN CHINA AND DECREASE IN INDIA.

EXAMPLEDECREASE IN DEMAND, WILL ULTIMATELY LEAD TO

DECREASE IN PRICE IN INDIA TILL THEY EQUATE EACH OTHER.

REALISTICALLY, THIS THEORY IN ITS ABSOLUTE FORM DOES NOT ACTUALLY HAPPEN BECAUSE OF

MARKET IMPERFECTIONS BROUGHT ABOUT BY DIFFERENT LEVELS OF TECHNOLOGY, COST OF

PRODUCTION, TAXATION SCHEMES, TRANSPORTATION COSTS ETC.

RELATIVE FORM OF PPPIT IS AN ALTERNATE VERSION OF PPP AND IT DOES

ACCOUNT FOR THE IMPERFECTIONS THAT MAY EXIST IN THE MARKET.

THIS FORM OF THE THEORY, ACKNOWLEDGES THE FACT THAT PRICES OF SIMILAR PRODUCTS OF

DIFFERENT COUNTRIES WILL NOT NECESSARILY BE THE SAME, EVEN IF MEASURED IN A COMMON

CURRENCY.

RELATIVE FORM OF PPPHOWEVER, IT STATES THAT THE RATE OF CHANGE

IN THE PRICES OF SIMILAR PRODUCTS IN DIFFERENT COUNTRIES WILL BE SOMEWHAT SIMILAR, WHEN MEASURED IN A COMMON

CURRENCY.

HERE, THE ASSUMPTION IS THAT THE TRANSPORTATION COSTS AND OTHER TRADE

BARRIERS REMAINS CONSTANT.

RELATIVE FORM OF PPPASSUME THAT THE TWO COUNTRIES HAVE ZERO INFLATION

AND THE CURRENT INTER COUNTRY TRADE OR THE EXCHANGE RATE BETWEEN THE TWO COUNTRIES IS IN

EQUILIBRIUM.

WITH THE PASSAGE OF TIME BOTH THE COUNTRIES WILL EXPERIENCE SOME INFLATION AND THE EXCHANGE RATE OR

TRADE BETWEEN THE TWO COUNTRIES WILL AUTOMATICALLY ADJUST ITSELF IN SUCH A MANNER SO

THAT THE DIFFERENCE IN THE RATE OF INFLATION WILL BE OFFSET. IN SUCH A SITUATION THE PRICES OF THE

PRODUCTS IN THE TWO COUNTRIES WILL APPEAR SIMILAR TO ITS CITIZENS.

RELATIVE FORM OF PPPTHIS WILL MEAN THAT THE CONSUMERS WILL

NOTE VERY LITTLE DIFFERENCE IN THEIR PURCHASING POWER WHEN COMAPARED

BETWEEN THE TWO COUNTRIES.

CONCLUSION OF THE RELATIVE FORM OF PPP IS THAT THE CHANGE IN THE EXCHANGE RATES IS EQUAL TO THE DIFFERNCE IN INFLATION RATES WHICH ALMOST NEUTRALISES THE EFFECT OF

EACH OTHER.

WHY PPP DOES NOT HOLD GOOD ?EXCHANGE RATES ARE ALSO AFFECTED BY

FACTORS OTHER THAN THE INFLATION DIFFERENTIAL. THEY MAY BE INCOME LEVEL,

GOVT.CONTROLS OR INTEREST RATE.

ASSUME THE INFLATION RATE IN INDIA TO BE 5% ABOVE TO THAT OF JAPAN. BASED ON THIS

INFORMATION THE PPP WOULD SUGGEST THAT THE INR SHOULD DEPRECIATE BY 5% AGAINST THE

JAPANESE YEN.

WHY PPP DOES NOT HOLD GOOD ?

NOW IF THE INDIAN GOVT. HAS IMPOSED RESTRICTIONS ON IMPORTS FROM JAPAN THEN THE INDIAN CONSUMERS AND FIRMS WILL NOT

BE ABLE TO ADJUST THEIR SPENDING IN REACTION TO THE INFLATION DIFFERENTIAL. THEREFORE, THE EXCHANGE RATE WILL NOT

ADJUST ITSELF IN REACTION TO DIFFERENCE IN INFLATION RATES.

WHY PPP DOES NOT HOLD GOOD ?IN THE EARLY 90’S MANY EUROPEAN COUNTRIES HAD HIGHER INFLATION THAN THE U.S., YET THE

CURRENCIES OF THESE COUNTRIES DID NOT DEPRECIATE AGSINT THE DOLLAR.

THIS WAS BECAUSE OF THE FACT THAT VERY HIGH INTEREST RATES IN THESE COUNTRIES ATTRACTED LARGE CAPITAL FLOWS FROM THE U.S. INVESTORS

THUS DEFYING THE THEORY OF PPP.

WHY PPP DOES NOT HOLD GOOD ?IN THE SAME PERIOD HONGKONG, SINGAPORE

AND SOUTH KOREA HAD QUIET HIGHER INFLATION RATES THAN THE U.S. BUT THEIR CURRENCIES DID NOT DEPRECIATE AGAINST THE DOLLAR BECAUSE OF THE GOVERNMENTAL POLICY OF THE U.S. TO CAPITALISE IN THE VIRGIN MARKETS OF THESE

PLACES.

VERY EARLY STAGES OF THE ACC – THIS WAS ONE OF THE REASONS FOR FIXED ADOPTING FIXED

EXCHANGE RATE SYSTEM.

WHY PPP DOES NOT HOLD GOOD ?THE PPP SUGGESTS THAT AS SOON AS THE PRICES

BECOME RELATIVELY HIGHER IN ONE COUNTRY, THE OTHER COUNTRY WILL DISCONTINUE

IMPORTING FROM THAT COUNTRY AND WILL SHIFT TO DOMESTIC RESOURCES.

HERE, IT SHOULD BE POINTED OUT THAT IT IS NOT NECESSARY THAT THERE WILL BE DOMESTIC

RESOURCES AVAILABLE IN QUALITY AND QUANTITY.

WHY PPP DOES NOT HOLD GOOD ?HOWEVER, IT SHOULD BE UNDERSTOOD THAT IN A LONG RUN OF OBSERVATIONS, IT HAS BEEN FOUND THAT THE EXCHANGE RATES HAVE BEEN AFFECTED

BY MANY MORE FACTORS AND AT DIFFERENT INTENSITY LEVELS.

THESE AFFECTING FACTORS HAVE ACTUALLY OFFSET THE IMPACT OF EACH OTHER IN THE LONG RUN.

THUS, IT IS CONCLUDED THAT THE CONTROVERSIES OF THE PPP THEORY HAVE ALWAYS STOOD THEIR

GROUND IN THE SHORT RUN . IN OTHER WORDS THE PPP DOES HOLD GOOD IN THE LONG RUN.

CHANGE IN INFLATION AND CURRENCY VALUE VIZ THE USA 1973 - 89

COUNTRY INFLATION RATIO TO USA

CHANGE IN VALUE OF CURRENCY

AUSTRALIA 4.4 1.6 1.8

AUSTRIA 2.1 0.8 0.7

CANADA 3.2 1.1 1.2

FRANCE 3.3 1.2 1.4

CHANGE IN INFLATION AND CURRENCY VALUE VIZ THE USA 1973 - 89

COUNTRY INFLATION RATIO TO USA CHANGE IN VALUE OF

CURRENCY

GERMANY 1.7 0.6 0.7

GREECE 14.4 5.1 5.3

ITALY 4.9 1.8 2.4

JAPAN 2.2 0.8 0.5

CHANGE IN INFLATION AND CURRENCY VALUE VIZ THE USA 1973 – 89

COUNTRY INFLATION RATIO TO USA CHANGE IN VALUE OF

CURRENCY

KOREA 5.8 2.1 1.7

SWEDEN 3.7 1.3 1.5

SWITZERLAND 1.7 0.6 0.5

UK 4.9 1.8 1.5

CHANGE IN INFLATION AND CURRENCY VALUE VIZ THE USA 1973 – 89

COUNTRY INFLATION RATIO TO USA CHANGE IN VALUE OF

CURRENCY

TURKEY 278 99.3 151.6

INTEREST RATE PARITY(IRP)THIS THEORY PROVIDES A LINKAGE BETWEEN THE

FOREIGN EXCHANGE MARKET AND THE INTERNATIONAL MONEY MARKETS.

CONCLUDING OBSERVATION OF THE THEORY

THE DIFFERENCE IN THE NATIONAL INTEREST RATES ON SECURITIES WITH SIMILAR RISK & MATURITY

SHOULD BE EQUAL TO, BUT OPPOSITE IN SIGN, TO THE FORWARD DISCOUNT OR PREMIUM FOR A

FOREIGN CURRENCY.

EXAMPLE OF (IRP)Assume that an investor has $1000. Now, if the

investor chooses to invest in a dollar money market instrument, he would earn the dollar

based rate of interest.

He may however, choose to invest in a Swiss Franc money market instrument, which would naturally be of the same risk profile and same

maturity period and thus earn returns as per the Francs based rate of interest.

EXAMPLE OF (IRP)To do this he would be required to exchange the

Dollars for Francs at the spot rate of exchange, then invest the Francs in a Franc money market instrument.

Next, if he wants to avoid any risk of change in the exchange rate, he would enter into a forward

transaction to sell the Francs ( period being the period of the investment).

At the end of the Forward transaction period he would convert the resulting proceed back to Dollars.

EXAMPLE OF (IRP)Assume that the returns he would have got, if he

had directly invested in a Dollar based money market instrument is $ 200, thereby making the

amount to be $1200.

The final outcome of investment he actually made in Franc based money market (finally

converted in to Dollars) is also $1200(assume).

EXAMPLE OF (IRP)In such a situation, it seems that the return in terms of Dollars are equal between the two

alternative money market investments.

Here, the Spot & Forward rates are said to be at Interest rate parity.

The transaction is called “Covered” as because the exchange rate for converting the Francs back to Dollars are locked by the forward transaction.

EXAMPLE OF (IRP)Therefore, if the result of the two alternatives is equal, it will be found that the difference in the

interest rates of the two separate money markets is actually offset by the difference in the Spot and

Forward exchange rates.IRP EXAMPLE.xlsx