This document discusses several economic theories related to exchange rates between Pakistan and the US: 1) Purchasing power parity (PPP) suggests exchange rates adjust for inflation, but it does not hold for Pakistan-US rates due to imperfect substitutes between goods and other factors influencing exchange rates. 2) Interest rate parity (IRP) equalizes interest rate differentials and forward/spot exchange rates, but increasing interest rates in one country increase forward contracts for its currency. 3) Interest rate expectation theory (IFE) describes how interest rate changes, rather than just inflation, impact nominal and real interest rates and exchange rates. Currencies with higher interest rates are expected to depreciate.

1. Does IRP, PPP and IFE exist in
Pakistan V/S US exchange rates
Muhammad Bilal SP16-BBA-008
Muhammad Irfan SP16-BBA023

2. What is PPP?
Purchasing power theory is a theory which attempts to adjust the
effect of inflation with exchange rate.
Example:
When inflation raise in any country the demand of foreign currency for
that particular country increase as a result exchange rate increases.

3. Types of PPP
• Absolute form of PPP
Absolute form of PPP says that without international barriers
customers can shift there demand
• Relative form of PPP
Relative form of PPP says that transportation cost, tariffs and
transaction cost exist

4. Derivation of purchasing power parity

5. Does PPP exist in Pakistan and US exchange rates
PPP does not exist in Pakistan and US exchange rates because of the
following reasons
• Goods are not perfect substitute for each others in both countries
• Not only inflation effect exchange rate but other factors also exist
such as interest rate, expectations, government control and income
level of the people

6. What is IFE?
IFE describe the effect of change in interest rate rather then the
inflation rates usually interest rates and inflation are highly correlated
when interest rate increase in a country it is assumed to increase in
inflation.
It describe the effect of nominal interest rate and real interest rate with
respect to exchange rate
A currency with higher nominal interest is expected to deprecate
against the currency with lower nominal interest.

7. Derivation of IFE

8. What is IRP?
Interest rate parity is a theory in which the interest rate differential
between two countries is equal to the differential between the forward
exchange rate and the spot exchange rate.
When interest rate increase in a country the amount of forward
contract for the currency of that particular currency in increased as
result investors cannot take benefit

9. Derivation of IRP