Theories of Exchange Rate Determination

Theories of exchange rates determination have changed since the exchange rate system
shifted to the floating rates system. Traditional theories, developed during the period of fixed
exchange rates, including the elasticity approach and the absorption approach, focused
mainly on the real sector. However, especially in the current period of floating exchange
rates, the monetary sector is another important element determining exchange. Exchange rate
is a function of many a things. On the basis of these factors many theories have been
formulated to determine the rate of exchange between different currencies. Some of the
important theories we will discuss here in this section/chapter.

1. The Purchasing Power Parity Theory

The purchasing power parity theory enunciates the determination of the rate of exchange
between two inconvertible paper currencies. Although this theory can be traced back to
Wheatley and Ricardo, yet the credit for developing it in a systematic way has gone to the
Swedish economist Gustav Cassel.
This theory states that the equilibrium rate of exchange is determined by the equality of the
purchasing power of two inconvertible paper currencies. It implies that the rate of exchange
between two inconvertible paper currencies is determined by the internal price levels in two
countries.
There are two versions of the purchasing power parity theory:
(i) The Absolute Version and
(ii) The Relative Version.
(i) The Absolute Version:- According to this version of the purchasing power parity theory,
the rate of exchange should normally reflect the relation between the internal purchasing
power of the different national currency units. In other words, the rate of exchange equals the
ratio of outlay required to buy a particular set of goods at home as compared with what it
would buy in a foreign country. It may be illustrated with an example.
Suppose 10 units of commodity X, 12 units of commodity Y and 15 units of commodity Z
can be bought through spending Rs. 1500 and the same quantities of X, Y and Z commodities
can be bought in the United States at an outlay of 25 dollars. It signifies that the purchasing
power of 25 dollars is equivalent to that of Rs. 1500 in their respective countries. That can
form the basis for determining the rate of exchange between rupee and dollar.
The exchange rate between them can be expressed as:
The absolute version of the purchasing power parity theory is, no doubt, quite simple and
elegant, yet it has certain shortcomings. Firstly, this version of determining exchange rate is
of little use as it attempts to measure the value of money (or purchasing power) in absolute
terms. In fact, the purchasing power is measured in relative terms. Secondly, there are
differences in the kinds and qualities of products in the two countries.
These diversities create serious problem in the equalisation of product prices in different
countries. Thirdly, apart from the differences in quality and kind of goods there are also
differences in the pattern of demand, technology, transport costs, tariff structures, tax
policies, extent of state intervention and control and several other factors. These differences
prohibit the measurement of exchange rate in two or more currencies in strict absolute terms.
(ii) The Relative Version:- The relative version of Cassel’s purchasing power parity theory
attempts to explain the changes in the equilibrium rate of exchange between two currencies.
It relates the changes in the equilibrium rate of exchange to changes in the purchasing power
parities of currencies. In other words, the relative changes in the price levels in two countries
between some base period and current period have vital bearing upon the exchange rates of
currencies in the two periods.
According to this version, the equilibrium rate of exchange in the current period (R1) is
determined by the equilibrium rate of exchange in the base period (R1) and the ratio of price
indices of current and base period in one country to the ratio of price indices of current and
base periods in the other country.

In the above expression, R1 is the rate of exchange in the current period and R0 is the rate of
exchange in the base period or the original rate of exchange. PB1 and PB0 are the price indices
in country B in the current and base periods respectively. PA1 and PA0 are the price indices in
the current and base periods respectively in the country A.
To illustrate, it is supposed that the original or base period rate of exchange between rupee
and dollar was $ 1 = Rs. 50. The price index in India (country B) in the current period (PB1) is
180 and the price index in the U.S.A. (country A) in the current period is 150. The price
indices of two countries in the base period were 100.

It shows that rupee has depreciated while dollar has appreciated between the two periods.

If the price level in India (B) has risen between the two periods at a relatively lesser rate than
in the U.S.A., the exchange rate of rupee with dollar will appreciate. The dollar on the
opposite will show some depreciation.
It is illustrated through the following hypothetical example:

Thus rupee has appreciated while the dollar has depreciated between the two time periods.

It is, of course, true that the purchasing power parity between the two currencies is
determined by the quotient of their respective purchasing power. This parity is modified by
the cost of transportation including freights, insurance and other charges. These costs lay
down the limits within which the rate of exchange will fluctuate.
The upper limit is called as the commodity export point whereas the lower limit is termed as
the commodity import point. These limits are not fixed as the gold specie points. Since the
purchasing power parity itself is a moving parity on account of the price variations in the two
countries, the limits within which it fluctuates are also of a moving character.

The purchasing power parity theory is explained through Fig. 22.7.

In Fig. 22.7, the purchasing power parity curve is of a fluctuating character. It signifies a
moving parity. Along with it, the curves indicating commodity export and commodity import
points also fluctuate. The market rate of exchange is determined by the intersection of
demand curve DD and supply curve SS of foreign exchange.
The market rate of exchange is OR and the quantity of foreign exchange demanded and
supplied is OQ. When the demand for and supply of foreign exchange change, the demand
and supply curves can undergo shifts as shown by D1 and S1 curves.
Accordingly, there will be variations in the market rate of exchange around the normal rate of
exchange determined by the purchasing power parity. The market rate of exchange, however,
will invariably lie between the limits specified by the commodity export and commodity
import points.
Criticism:
The purchasing power parity theory has met with severe criticism from the economists
on the following main grounds:
(i) Direct Functional Relation between Exchange Rate and Purchasing Powers:- This
theory assumes a direct functional relation between the purchasing powers of two currencies
and the exchange rate. In practice, there is no such precise link between the purchasing power
of the currency and the rate of exchange. Apart from the purchasing power, the rate of
exchange is influenced by several other factors such as capital flows, BOP situation,
speculation, tariff structures etc. The purchasing power parity theory overlooks all these
influences.
(ii) General Price Level:- The PPP theory determines the rate of exchange through the
indices of general price levels in the two countries. Since the general price level is inclusive
of prices of domestically and internationally traded goods, the theory rests upon the implicit
assumption that the prices of these two categories of goods vary equi-proportionately and in
the same direction in both the countries. But it is often found that the prices of internally and
internationally traded goods move disproportionately and sometimes even in opposite
directions.
Therefore, critics suggested that the rate of exchange should be related to the price indices
based upon the internationally traded goods. According to them, the prices of commodities
produced and used only in the home country can have no impact on the foreign exchange
rate. Keynes has, however, objected to such thinking. According to him, “Confined to
internationally traded commodities, the purchasing power parity theory becomes an empty
truism.”

(iii) Problems in the Construction of Price Index Numbers:- The major objection against
the PPP theory is concerned with the use of price- indices as the basis for measuring the
purchasing power of currencies in different countries. The price index numbers are of
different kinds that raises the preliminary problem of the choice of the most appropriate price
index.
Another problem is that the price index numbers of two countries may not be comparable on
account of difference in base period, choice of commodities and their varieties, averages and
weights assigned to different items. Given such diverse problems in the construction of price
index numbers in two countries, it seems difficult to have a true measure of the purchasing
power parity.
(iv) Relationship between Price Level and Exchange Rate:- The PPP theory suggests that
the change in price level is the cause and the change in exchange rate is an effect. The
changes in prices induce the changes in exchange rates. The theory repudiates that changes in
exchange rates can cause changes in price level. In fact the chain of causation in the PPP
theory is faulty and misleading. Depreciation in exchange rate can stimulate exports and
restrict imports. The reduced supplies for domestic market are likely to push up prices in the
home country.
In foreign country the prices are likely to fall. Thus the exchange rate changes may induce the
changes in price level. In this context, Halm pointed out that domestic prices follow rather
than precede the movement of exchange rate. In his words, “A process of equalisation
through arbitrage takes place so automatically that the national prices of commodities seem to
follow rather than to determine the movement of the exchange rate.”
(v) Neglect of Capital Account:- This theory can be applicable to only those countries in
case of which the BOP is constituted only by the merchandise trade account. It overlooks
completely, the capital transactions and hence is not relevant for those countries in case of
which the capital account is of prime significance. In this context, Kindelberger remarked
that the PPP theory was designed for trader nations and gives little guidance to a country
which is both a trader and a banker.
(vi) Presumption of BOP Equilibrium:- In its relative version, the PPP theory presumes
that the BOP in the base period was in equilibrium. Given this assumption, the theory
proceeds to determine new rate of exchange. Such an assumption may not be true. It may be
difficult to locate such a base period because the given country might have been faced with a
permanent BOP disequilibrium.
(vii) No Structural Changes:- This theory assumes that there are no structural changes in the
factors which underlie the equilibrium in the base period. Such factors include changes in
tastes or preferences, productive resources, technology etc. The assumption related to
constancy of structural factors is clearly unrealistic and the exchange rate is bound to be
affected by the changes in these factors.
(viii) Absence of Capital Movements:- The PPP theory related exchange rate exclusively to
the internal price changes in the two countries. It, thereby, assumed implicitly that there were
zero capital movements. Such an assumption is completely invalid. The changes in capital
flow have significant bearing upon the exchange rate, through their effects upon the demand
for and supply of domestic and foreign currencies. The impact of capital movements upon the
rate of exchange had been neglected by this theory.
(ix) Neglect of Elasticity of Reciprocal Demand:- Another defect in the PPP theory,
exposed by Keynes, was its failure to consider the elasticity of reciprocal demand. The rate of
exchange between currencies of two countries is determined not only by changes in relative
prices but also by elasticities of reciprocal demand.
(x) No Change in Barter Terms of Trade:- The PPP theory relies upon still another
assumption that there is no change in barter terms of trade between two countries. Even this
assumption is not valid as there are frequent changes in the barter terms of trade on account
of several factors such as supply of exported goods, demand for foreign goods, external loans
etc.
(xi) Neglect of Demand and Supply Forces:- The rate of exchange is not influenced only by
the relative price changes in two countries. The demand for and supply of foreign exchange
are the fundamental forces to determine the equilibrium rate of exchange. These forces are
influenced, apart from transactions of goods, also by such factors as capital flow, cost of
transport, insurance, banking etc. But the PPP theory gives little importance to the forces of
demand for and supply of foreign exchange.

(xii) Neglect of Aggregate Income and Expenditure:- This theory has been found to be
deficient by Ragnar Nurkse on the ground that it considers only the price movement as the
determinant of exchange rate. The variations in aggregate income and expenditure that can
have effect upon the foreign exchange rate through their effect upon the volume of foreign
trade were completely overlooked by this theory.
According to him, the PPP theory “treats demand simply as a function of price, leaving out of
account the wide shifts in the aggregate income and expenditure which occur in the business
cycle (as a result of market forces or government policies), and which lead to wide
fluctuations in the volume and hence the value of foreign trade even if prices or price
relationships remain the same.”
(xiii) Static Theory:- The PPP theory attempts to determine equilibrium rate of exchange
under static conditions such as constancy of tastes and preferences, absence of capital
movements, absence of transport costs, no changes in tariff, constant technology, absence of
speculation etc. It is highly unrealistic to determine exchange rate with all these over-
simplifying assumptions. In the actual dynamic realities, this theory fails altogether.
(xiv) Assumptions of Free Trade and Laissez Faire:- This theory rests on the assumptions
of free international trade and laissez faire. It means the government does not resort to tariff
or non-tariff restrictions upon trade. Even these assumptions do not hold valid in actual
reality. There is frequent use of tariffs, quotas and other controls by the governments in both
advanced and poor countries. The restrictions on trade do have a definite impact upon the rate
of exchange. It signifies that the PPP theory is completely incapable of determining the rate
of exchange in actual life.
(xv) Inexact Theory:- Vanek held the belief that the PPP theory at best could serve as a
crude approximation of the equilibrium rate of exchange. With its over-simplifying
assumptions, it can neither exactly measure the rate of exchange nor can make a precise
forecast of it over future period. In this context Halm commented, “Purchasing power parities
cannot be used to compute equilibrium rates or to gauge with precision deviations from
international payments equilibrium.”
(xvi) Change in International Economic Relations:- This theory fails to take cognizance of
change in international economic relations. If originally trade was taking place between two
countries, the appearance of a third country either as a purchaser or as a buyer of a particular
commodity can have a significant effect on the volume and direction of trade as well as on
demand and supply conditions pertaining to the foreign exchange.
Therefore, this theory is not capable of providing a proper measure of rate of exchange in the
more realistic conditions of multi-country trade.
(xvii) Relevant for Long Period:- The PPP theory can be considered relevant only in the
long period when the disturbances are of purely monetary character. During 1980’s, the
exchange rates were found to deviate from those suggested by the purchasing power parities.
No doubt, there are serious theoretical and practical deficiencies in the PPP theory, yet it is
indisputably a highly sensible explanation of rate of exchange in such countries where the
price movements have a major impact on the exchange rate.
This theory can explain the determination of rate of exchange not only under inconvertible
paper standard but under every possible monetary system. The long term tendency of
exchange rate can be stated more appropriately through relative price movements and that
underlines the practical importance of this theory.
Empirical Tests of the PPP Hypothesis
Despite weaknesses of both the absolute and relative versions of the PPP theory, the
assumptions of this theory are central to many a model. The empirical studies have been
made to assess the validity of the PPP hypothesis. These studies have attempted to deal with
three issues.
First, whether the Law of One Price holds and whether it is possible to construct price indices
that would follow that law. The studies made in this regard attempted by Isard (1977) and
Kravis and Lipsey (1978) have given the conclusion that the Law of One Price does not hold
true. They also indicate that changes in exchange rate result in variations in relative prices
that make it apparently impossible to construct price indices for which the Law of One Price
will hold.
Second, the empirical studies attempt to estimate the generalised form of equation and test
whether the parameters differ significantly or not from those predicted by PPP. In this
connection, the regression-based studies tend to suggest that the PPP hypothesis is not
acceptable in the short term. It may, however, do better in the long run.
Third, the issue is whether or not PPP provides efficient forecasts of exchange rate
movements over time. In this regard, the time series are based on more sophisticated models
involving interest rates, rational expectations and price levels. They proceed to examine the
markets. The evidence, in this context, is conflicting. While Mac Donald (1985) concluded
that the market was efficient, Frankel and Froot (1985) arrived at the opposite conclusion.
According to Sodersten and Reed, the empirical evidence related to the PPP, is rather mixed.
The evidence on balance is against this theory except in the long run. In their words, “We
may therefore feel that we must look at models that embody one or other of the PPP
hypothesis with some skepticism.”
2. Interest Rate Parity Theory (IRP)
Interest Rate Parity (IRP) is a theory in which the differential between the interest rates of
two countries remains equal to the differential calculated by using the forward exchange rate
and the spot exchange rate techniques. Interest rate parity connects interest, spot exchange,
and foreign exchange rates. It plays a crucial role in Forex markets.
IRP theory comes handy in analyzing the relationship between the spot rate and a relevant
forward (future) rate of currencies. According to this theory, there will be no arbitrage in
interest rate differentials between two different currencies and the differential will be
reflected in the discount or premium for the forward exchange rate on the foreign exchange.
The theory also stresses on the fact that the size of the forward premium or discount on a
foreign currency is equal to the difference between the spot and forward interest rates of the
countries in comparison.
Example
Let us consider investing € 1000 for 1 year. As shown in the figure below, we'll have two
options as investment cases −

Case I: Home Investment

In the US, let the spot exchange rate be $1.2245 / €1.
So, practically, we get an exchange for our €1000 @ $1.2245 = $1224.50
We can invest this money $1224.50 at the rate of 3% for 1 year which yields $1261.79 at the
end of the year.
Case II: International Investment
We can also invest €1000 in an international market, where the rate of interest is 5.0% for 1
year.
So, €1000 @ of 5% for 1 year = €1051.27
Let the forward exchange rate be $1.20025 / €1.
So, we buy forward 1 year in the future exchange rate at $1.20025/€1 since we need to
convert our €1000 back to the domestic currency, i.e., the U.S. Dollar.
Then, we can convert € 1051.27 @ $1.20025 = $1261.79
Thus, when there is no arbitrage, the Return on Investment (ROI) is equal in both cases,
regardless the choice of investment method.
Arbitrage is the activity of purchasing shares or currency in one financial market and selling
it at a premium (profit) in another.
Covered Interest Rate Parity (CIRP)
According to Covered Interest Rate theory, the exchange rate forward premiums (discounts)
nullify the interest rate differentials between two sovereigns. In other words, covered
interest rate theory says that the difference between interest rates in two countries is nullified
by the spot/forward currency premiums so that the investors could not earn an arbitrage
profit.
Example
Assume Yahoo Inc., the U.S. based multinational, has to pay the European employees in
Euro in a month's time. Yahoo Inc. can do this in many ways, one of which is given below −
 Yahoo can buy Euro forward a month (30 days) to lock in the exchange rate. Then it
can invest this money in dollars for 30 days after which it must convert the dollars to
Euro. This is known as covering, as now Yahoo Inc. will have no exchange rate
fluctuation risk.
 Yahoo can also convert the dollars to Euro now at the spot exchange rate. Then it can
invest the Euro money it has obtained in a European bond (in Euro) for 1 month
(which will have an equivalently loan of Euro for 30 days). Then Yahoo can pay the
obligation in Euro after one month.
Under this model, if Yahoo Inc. is sure that it will earn an interest, it may convert fewer
dollars to Euro today. The reason for this being the Euro’s growth via interest earned. It is
also known as covering because by converting the dollars to Euro at the spot rate, Yahoo is
eliminating the risk of exchange rate fluctuation.
Uncovered Interest Rate Parity (UIP)
Uncovered Interest Rate theory says that the expected appreciation (or depreciation) of a
particular currency is nullified by lower (or higher) interest.
Example
In the given example of covered interest rate, the other method that Yahoo Inc. can
implement is to invest the money in dollars and change it for Euro at the time of payment
after one month.
This method is known as uncovered, as the risk of exchange rate fluctuation is imminent in
such transactions.
Covered Interest Rate and Uncovered Interest Rate
Contemporary empirical analysts confirm that the uncovered interest rate parity theory is not
prevalent. However, the violations are not as huge as previously contemplated. The
violations are in the currency domain rather than being time horizon dependent.
In contrast, the covered interest rate parity is an accepted theory in recent times amongst the
OECD economies, mainly for short-term investments. The apparent deviations incurred in
such models are actually credited to the transaction costs.
Implications of IRP Theory
If IRP theory holds, then it can negate the possibility of arbitrage. It means that even if
investors invest in domestic or foreign currency, the ROI will be the same as if the investor
had originally invested in the domestic currency.
 When domestic interest rate is below foreign interest rates, the foreign currency must
trade at a forward discount. This is applicable for prevention of foreign currency
arbitrage.
 If a foreign currency does not have a forward discount or when the forward discount
is not large enough to offset the interest rate advantage, arbitrage opportunity is
available for the domestic investors. So, domestic investors can sometimes benefit
from foreign investment.
 When domestic rates exceed foreign interest rates, the foreign currency must trade at
a forward premium. This is again to offset prevention of domestic country arbitrage.
 When the foreign currency does not have a forward premium or when the forward
premium is not large enough to nullify the domestic country advantage, an arbitrage
opportunity will be available for the foreign investors. So, the foreign investors can
gain profit by investing in the domestic market.

3. International Fisher Effect

The International Fisher Effect (IFE) is an economic theory stating that the expected disparity
between the exchange rate of two currencies is approximately equal to the difference between
their countries' nominal interest rates.

KEY TAKEAWAYS

 The International Fisher Effect (IFE) states that differences in nominal interest rates
between countries can be used to predict changes in exchange rates.
 According to the IFE, countries with higher nominal interest rates experience higher
rates of inflation, which will result in currency depreciation against other currencies.
  In practice, evidence for the IFE is mixed and in recent years direct estimation of
currency exchange movements from expected inflation is more common.
Understanding the International Fisher Effect (IFE)
The IFE is based on the analysis of interest rates associated with present and future risk-free
investments, such as Treasuries, and is used to help predict currency movements. This is in
contrast to other methods that solely use inflation rates in the prediction of exchange rate
shifts, instead functioning as a combined view relating inflation and interest rates to a
currency's appreciation or depreciation.
The theory stems from the concept that real interest rates are independent of other monetary
variables, such as changes in a nation's monetary policy, and provide a better indication of the
health of a particular currency within a global market. The IFE provides for the assumption
that countries with lower interest rates will likely also experience lower levels of inflation,
which can result in increases in the real value of the associated currency when compared to
other nations. By contrast, nations with higher interest rates will experience depreciation in
the value of their currency.

This theory was named after U.S. economist Irving Fisher.

Calculating the International Fisher Effect

IFE is calculated as:

For example, if country A's interest rate is 10% and country B's interest rate is 5%, country
B's currency should appreciate roughly 5% compared to country A's currency. The rationale
for the IFE is that a country with a higher interest rate will also tend to have a
higher inflation rate. This increased amount of inflation should cause the currency in the
country with a higher interest rate to depreciate against a country with lower interest rates.

The Fisher Effect and the International Fisher Effect

The Fisher Effect and the IFE are related models but are not interchangeable. The Fisher
Effect claims that the combination of the anticipated rate of inflation and the real rate of
return are represented in the nominal interest rates. The IFE expands on the Fisher Effect,
suggesting that because nominal interest rates reflect anticipated inflation rates and currency
exchange rate changes are driven by inflation rates, then currency changes are proportionate
to the difference between the two nations' nominal interest rates.

Application of the International Fisher Effect

Empirical research testing the IFE has shown mixed results, and it is likely that other factors
also influence movements in currency exchange rates. Historically, in times when interest
rates were adjusted by more significant magnitudes, the IFE held more validity. However, in
recent years inflation expectations and nominal interest rates around the world are generally
low, and the size of interest rate changes is correspondingly relatively small. Direct
indications of inflation rates, such as consumer price indexes (CPI), are more often used to
estimate expected changes in currency exchange rates.

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