BBF 212 Notes on Theories of the Exchange Rate
Transcript of BBF 212 Notes on Theories of the Exchange Rate
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Theories of the Exchange rateTheories of the Exchange rate
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Learning OutcomesLearning Outcomes
y At the end of this lecture, you will be
able;
y To understand the various theories of the
exchange rate
y To provide a critique of each theory of the
exchange rate
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IntroductionIntroduction
y There are various theories of the exchange
rate and these include;
y The Purchasing Power Parity Theory
(PPP)
y The law of one Price
y The Interest Rate Parity (IRT)
y The International Fischers Effect
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The PPPTheoryThe PPPTheory
y If two countries are on free paper
currencies, (nothing common between two
currencies) the rate of exchange between
the two currencies can be determined byreference to their purchasing power in
their respective countries.
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y Purchasing power of a unit of currency is
measured in terms of tradable
commodities; which is equivalent to the
amount of goods and services that can bepurchased with one unit of that currency.
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y Eg:- If a pair of shoes is sold for Shs.
4,000 in Uganda and if the same pair of
shoes is sold for $100 in the U.S.A, the
rate of exchange (ignoring transport costs)will be ; $ 100 = Shs.4000 or $1= Shs. 40.
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y If the price of the shoes moves up to
Shs.4,400 in Uganda on account of 10%
inflation, the exchange rate will adjust to
equate the purchasing power of the twocurrencies.
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y PPP theory also specifies that the
purchasing power of a currency (value of
the currency) will depend upon the price
level in that country.
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y The Absolute Version of PPP theory states
that the exchange rate between the
currencies of two countries would be
equal to the ratio of the price levels of thetwo countries measured by the respective
consumer price indices.
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y If the level of prices rises, the purchasing
power of the currency would fall and its
rate of exchange would also fall and if the
price level in a country falls thepurchasing power of the currency would
rise and consequently its rate of exchange
would also go up.
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y Thus, Current Exchange Rate = Price
level in the home country/Price level in
the foreign country
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Criticism of the PPP TheoryCriticism of the PPP Theory
yNo direct link between Purchasing Powerand Rate of Exchange.
y This theory ignores Capital Flows
between countries.y This theory does not consider the
extraneous factors such as interest rates,govt. interference, Business Cycle,
political influence, BOP adjustments,decline in foreign exchange reserves etc.,which may influence exchange rates.
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y This theory applies only to product
markets and not suitable for financial
markets.
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The Law of One PriceThe Law of One Price
y The law of one price states that in
competitive markets free of transportation
costs and barriers to trade(such as tariffs),
identical products sold in differentcountries must sell for the same price
when their price is expressed in terms of
the same currency.
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y For e.g., if the exchange rate between the
British pound and the U.S Dollar 1 pound
= $1.50, a jacket that retails for $75 in
New York should sell for 50 in London.
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y Consider what would happen if the jacket
costs 40 pounds in London ($60 in the
U.S.); at this price , it would pay a trader
to buy jackets in London and sell the inNew York(Arbitrage).
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y The trade would initially make a profit of
$15 on jacket by purchasing it for 40
pounds in London and selling it for $75 in
New York.
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y However, the increased demand for
jackets in London would raise the price in
London and the increased supply of the
same would lower their prices there. Thiswould continue until prices were
equalized.
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y Thus, prices might equalize when the
jacket costs 44 pounds ($66) in London &
$66 in New York (assuming no change in
the exchange rate of 1 = $ 1.50)
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Interest Rate Parity (IRP)TheoryInterest Rate Parity (IRP)Theory
yWhen PPP theory applies to product
markets, IRP condition applies to financial
markets.
y IRP theory postulates that the forward rate
differential in the exchange rate of two
currencies would equal the interest rate
differential between the two countries.
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y Thus it holds that the forward premium or
discount for one currency relative to
another should be equal to the ratio of
nominal interest rate on securities of equalrisk (and duration) denominated in two
currencies.
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y To a large extent, forward exchange rates
are based on interests rate differential.
This theory assumes that arbitrageurs will
intervene in the market whenever there isdisparity between forward rate differential
and interest rate differential. But such
intervention by arbitrageurs will beeffective only in a market which is free
from controls and restrictions.
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y Another limitation is that regarding thediversity of short term interest rates in themoney market (where interest rates onTreasury Bills, Commercial Paper, etc.,differ) which creates problem while takinginterest rate parity. Extraneous economic and
political factors may sometimes enhancespeculative activities in the foreign exchangemarket. Market expectation also has stronginfluence in the determination of Forwardrate.
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International Fischers EffectInternational Fischers Effect
y According to the Relative Version of PPP
Theory one of the factors leading to
change in exchange rate between
currencies is inflation in the respectivecountries.
y As long as the inflation rate in the two
countries remains equal, the exchange ratebetween the currencies would not be
affected.
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y Irwin - Fishers Effect states that Nominal
interest rate comprises of Real interest
rate plus expected rate of inflation. So the
nominal interest rate will get adjustedwhen the inflation rate is expected to
change. The nominal interest rate will be
higher when higher inflation rate isexpected and it will be lower when lower
inflation rate is expected.
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y Since interest rates reflect expectations
about inflation, there is a link between
interest rates and exchange rates. Fishers
Open Proposition or International FishersEffect or Fishers Hypothesis articulates
that the exchange rate between the two
currencies would move in an equal butopposite direction to the difference in the
interest rates between two countries.
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y A country with higher nominal interest
rate would experience depreciation in the
value of its currency. Investors would like
to invest in assets denominated in thecurrencies which are expected to
depreciate only when the interest rate on
those assets is high enough to compensatethe loss on account of depreciation in the
currency value.
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y Conversely, investors would be willing to
invest in assets denominated in the
currencies which are expected to
appreciate even at a lower nominalinterest, provided the loss on account of
such lower interest rate is likely to
compensate by the appreciation in thevalue of the currency.
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y Thus Fischers effect articulates that the
anticipated change in the exchange rate
between two currencies would equal the
inflation rate differential between the twocountries, which in turn, would equal the
nominal interest rate differential between
these two countries.
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Tutorial questionsTutorial questions
y Provide a critique of PPP theory
y How is the PPP theory different from IRP
theory?
yWhat is the relevancy of the law of one
price to a country of your choice?
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