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International FinanceInternational FinanceUnit 2.3: Exchange RateUnit 2.3: Exchange RateDetermination: Theories (Focus onDetermination: Theories (Focus onPPP only)PPP only)

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Mrs. Charu Rastogi, Asst.ProfessorWhat Determines Exchange Rates?What Determines Exchange Rates? Short runShort run (hours, days, months) – related to(hours, days, months) – related tofinancial transfers because of the speed of thesefinancial transfers because of the speed of thesetransactions. Therefore:transactions. Therefore:Asset Market ApproachAsset Market Approach: differences in real interest rates,: differences in real interest rates,Shifting expectations of future exchange ratesShifting expectations of future exchange rates Medium runMedium run (years)(years) Economic cycles (Income differentials)Economic cycles (Income differentials) Long RunLong RunLook at next slideLook at next slide

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Mrs. Charu Rastogi, Asst.ProfessorLong Run Theories of ExchangeLong Run Theories of ExchangeRate DeterminationRate Determination Purchasing Power ParityPurchasing Power ParityAbsolute PPPAbsolute PPPRelative PPPRelative PPP Interest Rate ParityInterest Rate Parity International Fisher EquationInternational Fisher Equation Monetary Models (Asset Approach, CurrentMonetary Models (Asset Approach, CurrentAccount Monetary Model, Capital AccountAccount Monetary Model, Capital AccountMonetary Model, etc. )Monetary Model, etc. ) IS-LM ModelIS-LM Model

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Mrs. Charu Rastogi, Asst.ProfessorInterest Rate DifferentialsInterest Rate Differentials Short term real interest rate differentialsShort term real interest rate differentialsinfluence international capital movementsinfluence international capital movementsReal interest rate is nominal minus inflationReal interest rate is nominal minus inflation Low short term rates lead to less demandLow short term rates lead to less demandfor the currency and depreciationfor the currency and depreciation High rates lead to greater demand for theHigh rates lead to greater demand for thecurrency and appreciationcurrency and appreciation

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Mrs. Charu Rastogi, Asst.Professor30 35 40 45 50 55 60 65 70Millions of EurosImpact of interest rate differentialsImpact of interest rate differentialsDollarsper EuroS0AD0.80.75BD1S1

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Mrs. Charu Rastogi, Asst.ProfessorMarket expectationsMarket expectations As with stock markets, foreign exchangeAs with stock markets, foreign exchangemarkets react quickly to news or evenmarkets react quickly to news or evenrumors that point to future changesrumors that point to future changesaffecting ratesaffecting rates Future expectations can be self-fulfilling;Future expectations can be self-fulfilling;speculative bubbles can start without anyspeculative bubbles can start without anyreal information but can become selfreal information but can become selfsustaining for a whilesustaining for a while

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Mrs. Charu Rastogi, Asst.ProfessorDetermining Exchange RatesDetermining Exchange Rates (Continued)(Continued) Long runLong run (many years) - movements of(many years) - movements ofgoods, services, investment, influenced by:goods, services, investment, influenced by:Inflation rates (relative prices:Inflation rates (relative prices:Purchasing Power Parity (PPP)Purchasing Power Parity (PPP)

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Mrs. Charu Rastogi, Asst.ProfessorPurchasing Power Parity (PPP)Purchasing Power Parity (PPP)——some historysome history The theory of PPP has been around as long as paperThe theory of PPP has been around as long as papermoney. It is one of the oldest theories of exchange ratemoney. It is one of the oldest theories of exchange ratedetermination. Hence we present it first.determination. Hence we present it first. It was discussed in 16It was discussed in 16ththCentury Spain, for example.Century Spain, for example. It was last resurrected by Gustav Cassel in the periodIt was last resurrected by Gustav Cassel in the periodbetween WWI and WWII. He used it in discussions of howbetween WWI and WWII. He used it in discussions of howmuch European countries would have to either changemuch European countries would have to either changetheir exchange rates or their domestic price levels, giventheir exchange rates or their domestic price levels, giventhat WWI had changed the relative prices in the countriesthat WWI had changed the relative prices in the countries(causing different inflation rates in the countries).(causing different inflation rates in the countries). It is based on theIt is based on the Law Of One Price (LOOP)Law Of One Price (LOOP)..

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Mrs. Charu Rastogi, Asst.ProfessorLaw of One Price (LOOP)Law of One Price (LOOP) TheThe law of one pricelaw of one price is:is:““In a competitive market, if two goodsIn a competitive market, if two goodsare identical, then they should sell forare identical, then they should sell forthe same price.”the same price.” If the two goods were in the same place and bothIf the two goods were in the same place and bothavailable to customers, then customers wouldavailable to customers, then customers wouldalways choose the cheaper of the two goods,always choose the cheaper of the two goods,forcing the sellers of the more expensive one toforcing the sellers of the more expensive one tolower their price.lower their price.

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Mrs. Charu Rastogi, Asst.ProfessorArbitrageArbitrage If the two goods were not in the sameIf the two goods were not in the samemarket (place), thenmarket (place), then arbitragearbitrage wouldwouldoperate to equalize the prices.operate to equalize the prices. ArbitrageArbitrage is the process of buying or sellingis the process of buying or sellingsomething in order to exploit a pricesomething in order to exploit a pricedifferential so as to make a riskless profit.differential so as to make a riskless profit.Arbitrageurs seek to find and exploit priceArbitrageurs seek to find and exploit pricedifferentials between markets (across space).differentials between markets (across space).Arbitrageurs seek to carry goods across markets.Arbitrageurs seek to carry goods across markets.

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Mrs. Charu Rastogi, Asst.ProfessorSpeculationSpeculation If the two goods were not being demanded at theIf the two goods were not being demanded at thesame time, and the good was storable, thensame time, and the good was storable, thenspeculationspeculation would tend to equalize prices.would tend to equalize prices. SpeculationSpeculation is the holding of a good or security inis the holding of a good or security inthe hope of profiting from a future rise in price.the hope of profiting from a future rise in price.Speculators “arbitrage” across time. Speculators “carry”Speculators “arbitrage” across time. Speculators “carry”the goods across time.the goods across time.Because no one really knows the future, speculation isBecause no one really knows the future, speculation isinherently risky. (Spatial) arbitrage is not.inherently risky. (Spatial) arbitrage is not.

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Mrs. Charu Rastogi, Asst.ProfessorDeviations from LOOPDeviations from LOOP Carrying (storage) costsCarrying (storage) costs reduce the profits fromreduce the profits fromspeculation, andspeculation, and Transportation costsTransportation costs reduce the profits fromreduce the profits fromarbitrage.arbitrage. Transactions costsTransactions costs are other costs associated with aare other costs associated with atransaction, over and above the cost of the goodtransaction, over and above the cost of the goodwhich actually changes hands. These also reducewhich actually changes hands. These also reducethe profits associated with arbitrage andthe profits associated with arbitrage andspeculation.speculation. All three of these can result in deviations from theAll three of these can result in deviations from theLOOP.LOOP.

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Mrs. Charu Rastogi, Asst.ProfessorInternational LOOPInternational LOOP Transportation costs can be significant.Transportation costs can be significant. Legal barriers and tariffs may exist.Legal barriers and tariffs may exist. Some goods are not traded internationally. TheseSome goods are not traded internationally. Theseare goods for which inter-regional priceare goods for which inter-regional pricedifferentials cannot be eliminated by arbitrage.differentials cannot be eliminated by arbitrage.Examples ofExamples of nontradeable “goods”nontradeable “goods” are:are:HousesHousesMedical servicesMedical servicesGoods that are not available in all countriesGoods that are not available in all countries Goods that do not survive transportationGoods that do not survive transportation

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Mrs. Charu Rastogi, Asst.ProfessorInternational LOOPInternational LOOP (Continued)(Continued) When we add the complication of (flexible)When we add the complication of (flexible)exchange rates, we have to restate the lawexchange rates, we have to restate the lawof one price for international trade:of one price for international trade:““In a competitive market, similarIn a competitive market, similargoods in different countries shouldgoods in different countries shouldsell for the same price when the pricessell for the same price when the pricesare stated in the same currency.”are stated in the same currency.”In effect, this means that we have to apply the exchangerate to translate the prices of the goods to a commoncurrency. After doing so, the prices should be equal.

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Mrs. Charu Rastogi, Asst.ProfessorPurchasing Power ParityPurchasing Power Parity Purchasing power parity is based on the assumptionPurchasing power parity is based on the assumptionthat in absence of duties, transaction costs and otherthat in absence of duties, transaction costs and othercurbs, identical goods should have the same price incurbs, identical goods should have the same price indifferent countries when expressed in same currency.different countries when expressed in same currency. In other words, how much money would be needed toIn other words, how much money would be needed topurchase same amount of goods and services in twopurchase same amount of goods and services in twodifferent markets.different markets. This allows for calculating PPP exchange rates that canThis allows for calculating PPP exchange rates that canbe used to convert gross national income of countries inbe used to convert gross national income of countries interms of a single currency, usually the US dollar, toterms of a single currency, usually the US dollar, tofacilitate meaningful comparisons after adjusting forfacilitate meaningful comparisons after adjusting forprices.prices.

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Mrs. Charu Rastogi, Asst.ProfessorPurchasing Power ParityPurchasing Power Parity Purchasing power parity (PPP) is a theory whichPurchasing power parity (PPP) is a theory whichstates that exchange rates between currencies arestates that exchange rates between currencies arein equilibrium when their purchasing power is thein equilibrium when their purchasing power is thesame in each of the two countries.same in each of the two countries. This means that the exchange rate between twoThis means that the exchange rate between twocountries should equal the ratio of the twocountries should equal the ratio of the twocountries price level of a fixed basket of goodscountries price level of a fixed basket of goodsand services.and services. When a countrys domestic price level is increasingWhen a countrys domestic price level is increasing(i.e., a country experiences inflation), that(i.e., a country experiences inflation), thatcountrys exchange rate must depreciated incountrys exchange rate must depreciated inorder to return to PPP.order to return to PPP.

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Mrs. Charu Rastogi, Asst.ProfessorHow does the concept work?How does the concept work? A good example of the PPP concept is theA good example of the PPP concept is theBig Mac index compiled by the Economist. ItBig Mac index compiled by the Economist. Itassumes that over the long-term McDonaldsassumes that over the long-term McDonaldsBig Mac burger should have same price acrossBig Mac burger should have same price acrossthe world. Comparing the rupee price of thisthe world. Comparing the rupee price of thisburger with the price in the US gives the Rs-$ burger with the price in the US gives the Rs-$ exchange rateexchange rate on PPP basis. It is then possible on PPP basis. It is then possibleto compare this PPP exchange rate withto compare this PPP exchange rate withmarket rate and say if the rupee ismarket rate and say if the rupee isundervalued or overvalued.undervalued or overvalued.

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Mrs. Charu Rastogi, Asst.ProfessorHow does India beat Japan inHow does India beat Japan inPPP terms?PPP terms?

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Mrs. Charu Rastogi, Asst.ProfessorHow does India beat Japan inHow does India beat Japan inPPP terms?PPP terms? Under the regular method of GDP calculation,Under the regular method of GDP calculation,Indias economy is well behind Japan. EvenIndias economy is well behind Japan. Evenassuming an average economic growth rate ofassuming an average economic growth rate of7.5% over the next five years, the Indian7.5% over the next five years, the Indianeconomy will be only $2.9 trillion comparedeconomy will be only $2.9 trillion comparedwith Japans $6.69 trillion. However, pricewith Japans $6.69 trillion. However, pricelevels in Japan is much higher than that oflevels in Japan is much higher than that ofIndia or in the US.India or in the US.

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Mrs. Charu Rastogi, Asst.Professor When the International Monetary Fund adjustsWhen the International Monetary Fund adjuststhe national income of the two countries in termsthe national income of the two countries in termsof PPP exchange rates using US dollar, Indianof PPP exchange rates using US dollar, Indianeconomy grows to $4.46 trillion in 2011 because ofeconomy grows to $4.46 trillion in 2011 because oflower prices while Japan stays at $4.44 trillion.lower prices while Japan stays at $4.44 trillion. Essentially, it means that in total two countriesEssentially, it means that in total two countrieshave the same purchasing power, but because ofhave the same purchasing power, but because ofits much lower population average Japanese isits much lower population average Japanese isway ahead of average Indian in purchasingway ahead of average Indian in purchasingpower.power.

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Mrs. Charu Rastogi, Asst.ProfessorWhat is the relevance ofWhat is the relevance ofPPP?PPP? The concept of PPP is useful in comparingThe concept of PPP is useful in comparingquality or standard of living in differentquality or standard of living in differentcountries which may not be possible if one justcountries which may not be possible if one justlooked at per capita income. A lower incomelooked at per capita income. A lower incomemay allow a good quality of life in a countrymay allow a good quality of life in a countryof prices are low.of prices are low. For instance, a haircut may cost lot more inFor instance, a haircut may cost lot more inLondon than in Delhi. The major shortcomingLondon than in Delhi. The major shortcomingof PPP exchange rates is that these areof PPP exchange rates is that these aredifficult to measure.difficult to measure.

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Mrs. Charu Rastogi, Asst.ProfessorAbsolute Purchasing Power ParityAbsolute Purchasing Power Parity(PPP)(PPP) States that a bundle of goods should cost the sameStates that a bundle of goods should cost the samein Canada and the United States once you takein Canada and the United States once you takethe exchange rate into account.the exchange rate into account. Suppose particular basket of goods cost Rs. 1000/-Suppose particular basket of goods cost Rs. 1000/-in India and $ 100 in the U.S.A. That means thein India and $ 100 in the U.S.A. That means theexchanges rate would be Rs. 10 = $1exchanges rate would be Rs. 10 = $1

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Mrs. Charu Rastogi, Asst.ProfessorAbsolute Purchasing PowerAbsolute Purchasing PowerParity (PPP)Parity (PPP) Thus ifThus if ppdd is the domestic price andis the domestic price and ppff is theis theforeign price of the same good, andforeign price of the same good, and ee is theis thespot price of the foreign currency in thespot price of the foreign currency in thedomestic currency, thendomestic currency, thenppdd = e= eppffandandepepff / p/ pdd = 1 and= 1 and e = pe = pdd / p/ pff Or we can say…Or we can say…

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Mrs. Charu Rastogi, Asst.ProfessorAbsolute Purchasing Power ParityAbsolute Purchasing Power Parity(PPP)(PPP) IfIf PPdd is the domestic price level andis the domestic price level and PPff is the foreignis the foreignprice level, thenprice level, thenQ = ePQ = ePff / P/ PddQ=the real exchange rate and e = Spot exchangeQ=the real exchange rate and e = Spot exchangeraterate Or Q=S(Rs./$). (Or Q=S(Rs./$). (PPff / P/ Pdd )) If PPP holds, thenIf PPP holds, then QQ = 1= 1 andand e = Pe = Pd/d/ PPff.. This is referred to asThis is referred to as absolute purchasing powerabsolute purchasing powerparityparity Restated: The general level of prices, whenRestated: The general level of prices, whenconverted to a common currency, will be the sameconverted to a common currency, will be the samein every country.in every country.

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Mrs. Charu Rastogi, Asst.ProfessorRelative Purchasing PowerRelative Purchasing PowerParityParity This proposition states that the rate ofThis proposition states that the rate ofappreciation of a currency is equal to theappreciation of a currency is equal to thedifference in inflation rates between thedifference in inflation rates between theforeign and the home country.foreign and the home country. For example, if Canada has an inflation rateFor example, if Canada has an inflation rateof 1% and the US has an inflation rate of 3%,of 1% and the US has an inflation rate of 3%,the US Dollar will depreciate against thethe US Dollar will depreciate against theCanadian Dollar by 2% per year.Canadian Dollar by 2% per year.

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Mrs. Charu Rastogi, Asst.Professor Refer to accompanying videosRefer to accompanying videosAbsolute PPP:Absolute PPP:http://www.youtube.com/watch?v=oUzR7VO4_cghttp://www.youtube.com/watch?v=oUzR7VO4_cgRelative PPP:Relative PPP:http://www.youtube.com/watch?v=3NYUSd8t7dshttp://www.youtube.com/watch?v=3NYUSd8t7ds

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Mrs. Charu Rastogi, Asst.Professor