This presentation begins with reference to various exchange rate determination theories and explains purchasing power parity theory in detail.

1. International FinanceInternational Finance
Unit 2.3: Exchange RateUnit 2.3: Exchange Rate
Determination: Theories (Focus onDetermination: Theories (Focus on
PPP only)PPP only)

2. Mrs. Charu Rastogi, Asst.Professor
What Determines Exchange Rates?What Determines Exchange Rates?
 Short runShort run (hours, days, months) – related to(hours, days, months) – related to
financial transfers because of the speed of thesefinancial transfers because of the speed of these
transactions. 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

3. Mrs. Charu Rastogi, Asst.Professor
Long Run Theories of ExchangeLong Run Theories of Exchange
Rate 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, Current
Account Monetary Model, Capital AccountAccount Monetary Model, Capital Account
Monetary Model, etc. )Monetary Model, etc. )
 IS-LM ModelIS-LM Model

4. Mrs. Charu Rastogi, Asst.Professor
Interest Rate DifferentialsInterest Rate Differentials
 Short term real interest rate differentialsShort term real interest rate differentials
influence 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 demand
for the currency and depreciationfor the currency and depreciation
 High rates lead to greater demand for theHigh rates lead to greater demand for the
currency and appreciationcurrency and appreciation

5. Mrs. Charu Rastogi, Asst.Professor
30 35 40 45 50 55 60 65 70
Millions of Euros
Impact of interest rate differentialsImpact of interest rate differentials
Dollars
per Euro
S0
A
D0
.80
.75
B
D1
S1

6. Mrs. Charu Rastogi, Asst.Professor
Market expectationsMarket expectations
 As with stock markets, foreign exchangeAs with stock markets, foreign exchange
markets react quickly to news or evenmarkets react quickly to news or even
rumors that point to future changesrumors that point to future changes
affecting ratesaffecting rates
 Future expectations can be self-fulfilling;Future expectations can be self-fulfilling;
speculative bubbles can start without anyspeculative bubbles can start without any
real information but can become selfreal information but can become self
sustaining for a whilesustaining for a while

7. Mrs. Charu Rastogi, Asst.Professor
Determining Exchange RatesDetermining Exchange Rates (Continued)(Continued)
 Long runLong run (many years) - movements of(many years) - movements of
goods, 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)

8. Mrs. Charu Rastogi, Asst.Professor
Purchasing 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 paper
money. It is one of the oldest theories of exchange ratemoney. It is one of the oldest theories of exchange rate
determination. Hence we present it first.determination. Hence we present it first.
 It was discussed in 16It was discussed in 16thth
Century 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 period
between WWI and WWII. He used it in discussions of howbetween WWI and WWII. He used it in discussions of how
much European countries would have to either changemuch European countries would have to either change
their exchange rates or their domestic price levels, giventheir exchange rates or their domestic price levels, given
that 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)..

9. Mrs. Charu Rastogi, Asst.Professor
Law 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 goods
are identical, then they should sell forare identical, then they should sell for
the 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 both
available to customers, then customers wouldavailable to customers, then customers would
always 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 to
lower their price.lower their price.

10. Mrs. Charu Rastogi, Asst.Professor
ArbitrageArbitrage
 If the two goods were not in the sameIf the two goods were not in the same
market (place), thenmarket (place), then arbitragearbitrage wouldwould
operate to equalize the prices.operate to equalize the prices.
 ArbitrageArbitrage is the process of buying or sellingis the process of buying or selling
something in order to exploit a pricesomething in order to exploit a price
differential 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 price
differentials between markets (across space).differentials between markets (across space).
Arbitrageurs seek to carry goods across markets.Arbitrageurs seek to carry goods across markets.

11. Mrs. Charu Rastogi, Asst.Professor
SpeculationSpeculation
 If the two goods were not being demanded at theIf the two goods were not being demanded at the
same time, and the good was storable, thensame time, and the good was storable, then
speculationspeculation 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 in
the 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 is
inherently risky. (Spatial) arbitrage is not.inherently risky. (Spatial) arbitrage is not.

12. Mrs. Charu Rastogi, Asst.Professor
Deviations from LOOPDeviations from LOOP
 Carrying (storage) costsCarrying (storage) costs reduce the profits fromreduce the profits from
speculation, andspeculation, and
 Transportation costsTransportation costs reduce the profits fromreduce the profits from
arbitrage.arbitrage.
 Transactions costsTransactions costs are other costs associated with aare other costs associated with a
transaction, over and above the cost of the goodtransaction, over and above the cost of the good
which actually changes hands. These also reducewhich actually changes hands. These also reduce
the profits associated with arbitrage andthe profits associated with arbitrage and
speculation.speculation.
 All three of these can result in deviations from theAll three of these can result in deviations from the
LOOP.LOOP.

13. Mrs. Charu Rastogi, Asst.Professor
International 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. These
are goods for which inter-regional priceare goods for which inter-regional price
differentials 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

14. Mrs. Charu Rastogi, Asst.Professor
International 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 law
of one price for international trade:of one price for international trade:
““In a competitive market, similarIn a competitive market, similar
goods in different countries shouldgoods in different countries should
sell for the same price when the pricessell for the same price when the prices
are stated in the same currency.”are stated in the same currency.”
In effect, this means that we have to apply the exchange
rate to translate the prices of the goods to a common
currency. After doing so, the prices should be equal.

15. Mrs. Charu Rastogi, Asst.Professor
Purchasing Power ParityPurchasing Power Parity
 Purchasing power parity is based on the assumptionPurchasing power parity is based on the assumption
that in absence of duties, transaction costs and otherthat in absence of duties, transaction costs and other
curbs, identical goods should have the same price incurbs, identical goods should have the same price in
different 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 to
purchase same amount of goods and services in twopurchase same amount of goods and services in two
different markets.different markets.
 This allows for calculating PPP exchange rates that canThis allows for calculating PPP exchange rates that can
be used to convert gross national income of countries inbe used to convert gross national income of countries in
terms of a single currency, usually the US dollar, toterms of a single currency, usually the US dollar, to
facilitate meaningful comparisons after adjusting forfacilitate meaningful comparisons after adjusting for
prices.prices.

16. Mrs. Charu Rastogi, Asst.Professor
Purchasing Power ParityPurchasing Power Parity
 Purchasing power parity (PPP) is a theory whichPurchasing power parity (PPP) is a theory which
states that exchange rates between currencies arestates that exchange rates between currencies are
in equilibrium when their purchasing power is thein equilibrium when their purchasing power is the
same 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 two
countries should equal the ratio of the twocountries should equal the ratio of the two
countries' price level of a fixed basket of goodscountries' price level of a fixed basket of goods
and services.and services.
 When a country's domestic price level is increasingWhen a country's domestic price level is increasing
(i.e., a country experiences inflation), that(i.e., a country experiences inflation), that
country's exchange rate must depreciated incountry's exchange rate must depreciated in
order to return to PPP.order to return to PPP.

17. Mrs. Charu Rastogi, Asst.Professor
How 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 the
'Big Mac' index compiled by the Economist. It'Big Mac' index compiled by the Economist. It
assumes that over the long-term McDonald'sassumes that over the long-term McDonald's
Big Mac burger should have same price acrossBig Mac burger should have same price across
the world. Comparing the rupee price of thisthe world. Comparing the rupee price of this
burger 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 possible
to compare this PPP exchange rate withto compare this PPP exchange rate with
market rate and say if the rupee ismarket rate and say if the rupee is
undervalued or overvalued.undervalued or overvalued.

18. Mrs. Charu Rastogi, Asst.Professor
How does India beat Japan inHow does India beat Japan in
PPP terms?PPP terms?

19. Mrs. Charu Rastogi, Asst.Professor
How does India beat Japan inHow does India beat Japan in
PPP terms?PPP terms?
 Under the regular method of GDP calculation,Under the regular method of GDP calculation,
India's economy is well behind Japan. EvenIndia's economy is well behind Japan. Even
assuming an average economic growth rate ofassuming an average economic growth rate of
7.5% over the next five years, the Indian7.5% over the next five years, the Indian
economy will be only $2.9 trillion comparedeconomy will be only $2.9 trillion compared
with Japan's $6.69 trillion. However, pricewith Japan's $6.69 trillion. However, price
levels in Japan is much higher than that oflevels in Japan is much higher than that of
India or in the US.India or in the US.

20. Mrs. Charu Rastogi, Asst.Professor
 When the International Monetary Fund adjustsWhen the International Monetary Fund adjusts
the national income of the two countries in termsthe national income of the two countries in terms
of PPP exchange rates using US dollar, Indianof PPP exchange rates using US dollar, Indian
economy grows to $4.46 trillion in 2011 because ofeconomy grows to $4.46 trillion in 2011 because of
lower 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 countries
have the same purchasing power, but because ofhave the same purchasing power, but because of
its much lower population average Japanese isits much lower population average Japanese is
way ahead of average Indian in purchasingway ahead of average Indian in purchasing
power.power.

21. Mrs. Charu Rastogi, Asst.Professor
What is the relevance ofWhat is the relevance of
PPP?PPP?
 The concept of PPP is useful in comparingThe concept of PPP is useful in comparing
quality or standard of living in differentquality or standard of living in different
countries which may not be possible if one justcountries which may not be possible if one just
looked at per capita income. A lower incomelooked at per capita income. A lower income
may allow a good quality of life in a countrymay allow a good quality of life in a country
of prices are low.of prices are low.
 For instance, a haircut may cost lot more inFor instance, a haircut may cost lot more in
London than in Delhi. The major shortcomingLondon than in Delhi. The major shortcoming
of PPP exchange rates is that these areof PPP exchange rates is that these are
difficult to measure.difficult to measure.

22. Mrs. Charu Rastogi, Asst.Professor
Absolute 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 same
in Canada and the United States once you takein Canada and the United States once you take
the 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 the
exchanges rate would be Rs. 10 = $1exchanges rate would be Rs. 10 = $1

23. Mrs. Charu Rastogi, Asst.Professor
Absolute Purchasing PowerAbsolute Purchasing Power
Parity (PPP)Parity (PPP)
 Thus ifThus if ppdd is the domestic price andis the domestic price and ppff is theis the
foreign price of the same good, andforeign price of the same good, and ee is theis the
spot price of the foreign currency in thespot price of the foreign currency in the
domestic currency, thendomestic currency, then
ppdd = e= eppff
andand
epepff / p/ pdd = 1 and= 1 and e = pe = pdd / p/ pff
 Or we can say…Or we can say…

24. Mrs. Charu Rastogi, Asst.Professor
Absolute 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 foreign
price level, thenprice level, then
Q = ePQ = ePff / P/ Pdd
Q=the real exchange rate and e = Spot exchangeQ=the real exchange rate and e = Spot exchange
raterate
 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 power
parityparity
 Restated: The general level of prices, whenRestated: The general level of prices, when
converted to a common currency, will be the sameconverted to a common currency, will be the same
in every country.in every country.

25. Mrs. Charu Rastogi, Asst.Professor
Relative Purchasing PowerRelative Purchasing Power
ParityParity
 This proposition states that the rate ofThis proposition states that the rate of
appreciation of a currency is equal to theappreciation of a currency is equal to the
difference in inflation rates between thedifference in inflation rates between the
foreign and the home country.foreign and the home country.
 For example, if Canada has an inflation rateFor example, if Canada has an inflation rate
of 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 the
Canadian Dollar by 2% per year.Canadian Dollar by 2% per year.

26. 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

27. Mrs. Charu Rastogi, Asst.Professor