4.1 Theories of exchange rate determination
3 min read•july 24, 2024
Exchange rates play a crucial role in international finance. (PPP) and (IRP) are two key theories explaining how they're determined. PPP focuses on price levels, while IRP considers interest rate differences between countries.
The combines elements of both PPP and IRP. It emphasizes the impact of money supply and demand on exchange rates. Understanding these theories helps predict currency movements and informs financial decision-making in global markets.
Purchasing Power Parity and Interest Rate Parity
Principles of purchasing power parity
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- underpins PPP stating identical goods should have same price across countries when expressed in same currency (Big Mac Index)
- posits exchange rates adjust to equalize purchasing power of different currencies
- focuses on changes in exchange rates reflecting differences in between countries
- Assumes no transportation costs, trade barriers, perfectly competitive markets, homogeneous goods across countries
- PPP equation: where E is exchange rate and P is price level
- Real-world limitations due to non-tradable goods, quality differences, and market imperfections
Interest rate parity theory
- (CIRP) represents no- condition in forex markets
- determined by interest rate differentials under CIRP
- (UIRP) states expected future determined by interest rate differentials
- IRP equation: where i is interest rate, F is forward rate, S is spot rate
- Higher generally lead to currency appreciation, lower rates to depreciation
- Interest rate differentials drive between countries ()
- Assumes perfect capital mobility and risk neutrality
Monetary Approach and Theory Comparison
Monetary approach to exchange rates
- Emphasizes money supply, money demand, and price levels in determining exchange rates
- Assumes flexible prices, full employment, perfect capital mobility
- Relative money supply changes affect exchange rates directly
- Increase in domestic money supply typically leads to currency depreciation
- equation: where e is exchange rate, m is money supply, y is real income, v is velocity of money, * denotes foreign variables
- Incorporates both PPP and IRP principles in a unified framework
Comparison of exchange rate theories
- PPP focuses on goods market equilibrium, applicable long-term (GDP comparisons)
- IRP emphasizes financial market equilibrium, useful short-term (forex trading)
- Monetary approach combines PPP and IRP elements, medium to long-term applicability (policy analysis)
- PPP useful for long-term forecasting and comparing living standards across countries
- IRP valuable for short-term exchange rate predictions and currency trading strategies
- Monetary approach helps explain currency movements in response to monetary policy changes (quantitative easing)
- PPP ignores capital flows and non-tradable goods, IRP assumes perfect capital mobility
- Monetary approach may oversimplify complex economic relationships
- Combining theories provides comprehensive understanding of currency movements
- Each theory offers insights into different aspects of exchange rate determination
Key Terms to Review (26)
Absolute ppp: Absolute purchasing power parity (PPP) is an economic theory which posits that in the absence of transaction costs and trade barriers, identical goods should have the same price when expressed in a common currency. This concept underlines the relationship between exchange rates and price levels across different countries, suggesting that exchange rates will adjust to equalize the purchasing power of different currencies.
Arbitrage: Arbitrage is the practice of taking advantage of price differences in different markets for the same asset, allowing traders to buy low in one market and sell high in another. This process helps ensure that prices do not diverge significantly across markets, contributing to overall market efficiency. By exploiting these discrepancies, arbitrageurs play a crucial role in foreign exchange markets, affecting currency values and influencing exchange rate forecasting methods and models.
Behavioral finance: Behavioral finance is a field of study that combines psychology and economics to understand how individuals make financial decisions and how these decisions can deviate from traditional economic theories. This approach emphasizes the impact of cognitive biases, emotions, and social influences on investors' behavior, ultimately affecting market outcomes and exchange rates.
Capital Flows: Capital flows refer to the movement of money for the purpose of investment, trade, or business production across borders. This term encompasses a wide range of financial transactions, including foreign direct investment (FDI), portfolio investment, and other financial assets. Capital flows are influenced by various factors such as interest rates, economic stability, and investor sentiment, and they play a crucial role in determining exchange rates and the health of global economies.
Carry Trade: A carry trade is an investment strategy where an investor borrows money in a currency with a low interest rate and uses it to invest in a currency with a higher interest rate, aiming to profit from the difference in rates. This strategy is heavily influenced by market participants who seek to exploit interest rate differentials, and it can have significant impacts on foreign exchange market microstructure and exchange rate dynamics.
Covered Interest Rate Parity: Covered interest rate parity is a financial theory stating that the difference in interest rates between two countries is equal to the forward exchange rate premium or discount. This concept ensures that investors cannot make arbitrage profits from discrepancies in interest rates and exchange rates when the forward market is used to hedge against currency risk. It is foundational in understanding how arbitrage conditions, exchange rate theories, and monetary policy can affect international financial markets.
Currency intervention: Currency intervention refers to the actions taken by a government or central bank to influence the value of its currency in the foreign exchange market. These interventions can be direct, involving the buying or selling of currency, or indirect, using interest rates and other economic policies to affect currency value. The main goal is often to stabilize the currency, manage inflation, or achieve a competitive advantage in international trade.
Exchange rate regimes: Exchange rate regimes refer to the methods and systems that countries use to manage their currency's value in relation to other currencies. These regimes can vary from fixed, where a currency's value is pegged to another, to floating, where the value fluctuates based on market forces. Understanding these regimes is essential as they influence international trade, investment decisions, and monetary policies across different economies.
Fixed exchange rate: A fixed exchange rate is a currency system where the value of a currency is tied or pegged to another major currency, like the US dollar or gold. This system helps stabilize a country's currency by minimizing fluctuations, making it easier for businesses and investors to plan for the future. By maintaining a fixed rate, countries can influence their economic policies and trade relations more predictably, which ties into how exchange rates are determined, forecasted, and influenced by various factors.
Float exchange rate: A float exchange rate is a currency system where the value of a currency is determined by the market forces of supply and demand relative to other currencies. In this system, the exchange rate fluctuates freely, responding to changes in the economy, interest rates, and trade balances without direct government or central bank intervention.
Forward Exchange Rate: The forward exchange rate is a predetermined rate at which a currency can be exchanged for another currency at a future date. It is often used to hedge against potential fluctuations in exchange rates, allowing businesses and investors to lock in prices for future transactions. This concept connects closely with the mechanics of arbitrage and interest rate parity, as well as the various theories that explain how exchange rates are determined over time.
Fundamental analysis: Fundamental analysis is a method of evaluating securities by attempting to measure their intrinsic value through the examination of related economic, financial, and other qualitative and quantitative factors. This approach involves analyzing factors such as a country's economic indicators, interest rates, inflation, and political stability, which can directly influence currency values and exchange rates.
Inflation Rates: Inflation rates measure the rate at which the general level of prices for goods and services rises, eroding purchasing power. High inflation can impact foreign exchange rates, as currencies lose value relative to others, and influences investor behavior in the foreign exchange market. Additionally, understanding inflation rates is crucial when dealing with financial instruments like swaps, which may adjust for changes in currency value over time.
Interest Rate Parity: Interest rate parity is a fundamental principle in international finance that establishes a relationship between the interest rates of two countries and the expected changes in their exchange rates. This concept ensures that investors cannot make a risk-free profit by exploiting differences in interest rates between countries when investing in foreign currency-denominated assets, connecting various financial instruments and exchange rate movements.
Interest Rates: Interest rates represent the cost of borrowing money or the return on investment for savings, typically expressed as a percentage of the principal over a specific period. They play a crucial role in financial markets, influencing currency values, capital flows, and investment decisions across international borders.
John Maynard Keynes: John Maynard Keynes was a British economist whose ideas, known as Keynesian economics, fundamentally changed the theory and practice of macroeconomics and government economic policy. His work emphasized the importance of total spending in the economy and its effects on output and inflation, influencing theories of exchange rate determination and factors that influence exchange rates, particularly during periods of economic instability.
Law of One Price: The Law of One Price states that in efficient markets, identical goods should sell for the same price when expressed in a common currency, assuming no transportation costs and no differential taxes applied in different markets. This principle underpins various economic theories and helps explain the behavior of prices in international financial markets.
Milton Friedman: Milton Friedman was a prominent American economist and a key figure in the development of modern monetary theory and free-market economics. He is well-known for his belief that economic factors play a crucial role in determining exchange rates, which directly connects to theories of exchange rate determination and the various factors that influence currency values.
Monetary Approach: The monetary approach is a theory in exchange rate determination that emphasizes the role of money supply and demand in influencing currency values. It suggests that exchange rates are determined by the relative supply of money between countries, with currency value reflecting the purchasing power of money. This approach integrates aspects of both domestic and international monetary policies and posits that changes in money supply will ultimately affect price levels and, consequently, exchange rates.
Monetary Model: The monetary model is a framework used to determine exchange rates based on the supply and demand for money in different countries. This model connects money supply, interest rates, and inflation to predict how currency values fluctuate in the foreign exchange market. By assessing economic indicators like GDP and monetary policy, this model helps explain the relationship between a country’s economic conditions and its currency strength.
Purchasing Power Parity: Purchasing Power Parity (PPP) is an economic theory that states that in the long run, exchange rates should adjust so that identical goods in different countries have the same price when expressed in a common currency. This concept connects to international monetary systems, as it provides a framework for understanding how currencies should be valued relative to one another. It also plays a crucial role in explaining the implications of different exchange rate regimes and is fundamental to various theories of exchange rate determination and factors influencing exchange rates.
Relative PPP: Relative Purchasing Power Parity (PPP) is an economic theory that suggests that the exchange rate between two currencies will adjust to reflect changes in price levels between the two countries. This theory implies that if a country experiences higher inflation compared to another, its currency should depreciate relative to the other currency, maintaining equilibrium in purchasing power across nations.
Speculation: Speculation refers to the act of buying, holding, or selling assets with the expectation of making a profit based on future price movements. This concept is deeply connected to various financial instruments and market theories, particularly in how traders utilize currency futures and options to capitalize on anticipated fluctuations in exchange rates, informed by underlying economic factors and market dynamics.
Spot rate: The spot rate is the current exchange rate at which a currency can be bought or sold for immediate delivery. This rate reflects the real-time value of a currency in relation to another and is essential for various financial transactions and forecasting models. Understanding the spot rate is crucial for predicting future movements in exchange rates, valuing foreign investments, and effectively managing currency risk through swaps and other financial instruments.
Trade balances: Trade balances represent the difference between the value of a country's exports and imports over a specific period. A positive trade balance indicates a surplus, where exports exceed imports, while a negative trade balance reflects a deficit, where imports surpass exports. This concept is vital for understanding a country's economic health and its currency value in relation to exchange rates.
Uncovered Interest Rate Parity: Uncovered interest rate parity is an economic theory that posits that the difference in interest rates between two countries will be equal to the expected change in exchange rates between their currencies. This concept implies that investors should expect no arbitrage opportunities, as any potential gains from interest rate differentials will be offset by changes in currency values, linking it closely to the functioning of financial markets, exchange rate dynamics, and monetary policy effects.