This document discusses several exchange rate theories, including the traditional or elasticities approach, purchasing power parity (PPP), and interest rate parity (IRP). The traditional approach assumes an equilibrium exchange rate where a country's imports balance its exports. If imports exceed exports, the exchange rate will fall to make the country's exports cheaper and imports more expensive, balancing trade. PPP has both an absolute and relative form. In absolute PPP, similar goods should have the same price in different currencies. Relative PPP recognizes market imperfections but holds that inflation rates between countries will offset exchange rate changes over time. IRP links exchange and money markets, stating that interest rate differences between countries should equal forward exchange

1. EXCHANGE RATE THEORIES
TRADITIONAL 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.

2. EXCHANGE RATE THEORIES
IN 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.

3. EXCHANGE RATE THEORIES
ASSUMING 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.

4. EXCHANGE RATE THEORIES
PURCHASING 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”.

5. EXCHANGE RATE THEORIES
THIS 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.

6. EXAMPLE
SUPPOSE, 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.

7. EXAMPLE
DECREASE 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.

8. RELATIVE FORM OF PPP
IT 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.

9. RELATIVE FORM OF PPP
HOWEVER, 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.

10. RELATIVE FORM OF PPP
ASSUME 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.

11. RELATIVE FORM OF PPP
THIS 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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

19. 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

20. 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

21. 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

22. 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.

23. 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.

24. 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.

25. 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).

26. 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.

27. 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