bbf 212 notes on theories of the exchange rate

8/9/2019 BBF 212 Notes on Theories of the Exchange Rate

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Theories of the Exchange rateTheories of the Exchange rate

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Learning OutcomesLearning Outcomes

y At the end of this lecture, you will be

able;

y To understand the various theories of the

exchange rate

y To provide a critique of each theory of the

exchange rate

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IntroductionIntroduction

y There are various theories of the exchange

rate and these include;

y The Purchasing Power Parity Theory

(PPP)

y The law of one Price

y The Interest Rate Parity (IRT)

y The International Fischers Effect

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The PPPTheoryThe PPPTheory

y If two countries are on free paper

currencies, (nothing common between two

currencies) the rate of exchange between

the two currencies can be determined byreference to their purchasing power in

their respective countries.

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y Purchasing power of a unit of currency is

measured in terms of tradable

commodities; which is equivalent to the

amount of goods and services that can bepurchased with one unit of that currency.

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y Eg:- If a pair of shoes is sold for Shs.

4,000 in Uganda and if the same pair of

shoes is sold for $100 in the U.S.A, the

rate of exchange (ignoring transport costs)will be ; $ 100 = Shs.4000 or $1= Shs. 40.

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y If the price of the shoes moves up to

Shs.4,400 in Uganda on account of 10%

inflation, the exchange rate will adjust to

equate the purchasing power of the twocurrencies.

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y PPP theory also specifies that the

purchasing power of a currency (value of

the currency) will depend upon the price

level in that country.

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y The Absolute Version of PPP theory states

that the exchange rate between the

currencies of two countries would be

equal to the ratio of the price levels of thetwo countries measured by the respective

consumer price indices.

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y If the level of prices rises, the purchasing

power of the currency would fall and its

rate of exchange would also fall and if the

price level in a country falls thepurchasing power of the currency would

rise and consequently its rate of exchange

would also go up.

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y Thus, Current Exchange Rate = Price

level in the home country/Price level in

the foreign country

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Criticism of the PPP TheoryCriticism of the PPP Theory

yNo direct link between Purchasing Powerand Rate of Exchange.

y This theory ignores Capital Flows

between countries.y This theory does not consider the

extraneous factors such as interest rates,govt. interference, Business Cycle,

political influence, BOP adjustments,decline in foreign exchange reserves etc.,which may influence exchange rates.

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y This theory applies only to product

markets and not suitable for financial

markets.

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The Law of One PriceThe Law of One Price

y The law of one price states that in

competitive markets free of transportation

costs and barriers to trade(such as tariffs),

identical products sold in differentcountries must sell for the same price

when their price is expressed in terms of

the same currency.

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y For e.g., if the exchange rate between the

British pound and the U.S Dollar 1 pound

= $1.50, a jacket that retails for $75 in

New York should sell for 50 in London.

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y Consider what would happen if the jacket

costs 40 pounds in London ($60 in the

U.S.); at this price , it would pay a trader

to buy jackets in London and sell the inNew York(Arbitrage).

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y The trade would initially make a profit of

$15 on jacket by purchasing it for 40

pounds in London and selling it for $75 in

New York.

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y However, the increased demand for

jackets in London would raise the price in

London and the increased supply of the

same would lower their prices there. Thiswould continue until prices were

equalized.

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y Thus, prices might equalize when the

jacket costs 44 pounds ($66) in London &

$66 in New York (assuming no change in

the exchange rate of 1 = $ 1.50)

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Interest Rate Parity (IRP)TheoryInterest Rate Parity (IRP)Theory

yWhen PPP theory applies to product

markets, IRP condition applies to financial

markets.

y IRP theory postulates that the forward rate

differential in the exchange rate of two

currencies would equal the interest rate

differential between the two countries.

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y Thus it holds that the forward premium or

discount for one currency relative to

another should be equal to the ratio of

nominal interest rate on securities of equalrisk (and duration) denominated in two

currencies.

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y To a large extent, forward exchange rates

are based on interests rate differential.

This theory assumes that arbitrageurs will

intervene in the market whenever there isdisparity between forward rate differential

and interest rate differential. But such

intervention by arbitrageurs will beeffective only in a market which is free

from controls and restrictions.

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y Another limitation is that regarding thediversity of short term interest rates in themoney market (where interest rates onTreasury Bills, Commercial Paper, etc.,differ) which creates problem while takinginterest rate parity. Extraneous economic and

political factors may sometimes enhancespeculative activities in the foreign exchangemarket. Market expectation also has stronginfluence in the determination of Forwardrate.

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International Fischers EffectInternational Fischers Effect

y According to the Relative Version of PPP

Theory one of the factors leading to

change in exchange rate between

currencies is inflation in the respectivecountries.

y As long as the inflation rate in the two

countries remains equal, the exchange ratebetween the currencies would not be

affected.

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y Irwin - Fishers Effect states that Nominal

interest rate comprises of Real interest

rate plus expected rate of inflation. So the

nominal interest rate will get adjustedwhen the inflation rate is expected to

change. The nominal interest rate will be

higher when higher inflation rate isexpected and it will be lower when lower

inflation rate is expected.

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y Since interest rates reflect expectations

about inflation, there is a link between

interest rates and exchange rates. Fishers

Open Proposition or International FishersEffect or Fishers Hypothesis articulates

that the exchange rate between the two

currencies would move in an equal butopposite direction to the difference in the

interest rates between two countries.

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y A country with higher nominal interest

rate would experience depreciation in the

value of its currency. Investors would like

to invest in assets denominated in thecurrencies which are expected to

depreciate only when the interest rate on

those assets is high enough to compensatethe loss on account of depreciation in the

currency value.

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y Conversely, investors would be willing to

invest in assets denominated in the

currencies which are expected to

appreciate even at a lower nominalinterest, provided the loss on account of

such lower interest rate is likely to

compensate by the appreciation in thevalue of the currency.

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y Thus Fischers effect articulates that the

anticipated change in the exchange rate

between two currencies would equal the

inflation rate differential between the twocountries, which in turn, would equal the

nominal interest rate differential between

these two countries.

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Tutorial questionsTutorial questions

y Provide a critique of PPP theory

y How is the PPP theory different from IRP

theory?

yWhat is the relevancy of the law of one

price to a country of your choice?

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bbf 212 notes on theories of the exchange rate

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