Exchange Rate Determination

• There three theories of exchange rate

determination :
• Mint parity theory
• Purchasing power parity theory
• Interest Parity theory
• Balance of Payments theory or demand
and supply theory
 PPP THEORY
• The PPP principle, which was popularized
by Gustav Cassell in the 1920s is most
easily explained if we begin by considering
the connection between exchange arte
and local currency price of an individual
commodity o\in different countries . The
connection between exchange and
commodity price is known as the law of
one price .
• The law of one price states that in the absence
of frictions such as shipping costs and tariffs ,
the price of a product when converted into a
common currency such as the dollar ,using the
spot rate ,is the same in every country .
• Pusw= $4
• Pukw=£2.5
• The rate of exchange will be $/£=4/2.5=1.6
• Pus=S($/£) Pukw…………………….(1)
• For example ,if Puk =£2.5 , Pus=$4 and
S($/£) =1.70,THEN THE DOLLAR PRICE
OF WHEAT IN Britain is $4.25 /bushel .
With the US price of $4/bushel ,wheat
buyers will buy from the US AND NOT
FROM Britain ,forcing up the US price and
forcing down the British PROCE UNTILL
THEY SATISFY EQUATION (1)
 Absolute or Static Version Of PPP
Condition
• Pus=S($/£) Pukw
• Or
• S($/£)= Pus/Puk
• It takes into account the cost of basket of goods and
services in the US measured in dollar and in Britain in
pound.
• This means that even if the law of one price holds for
each individual good , Price indexes which depend on
the weights attached to each goodwill not conform the to
the law of one price . Partly for this reason an alternative
form of PPP Condition which is stated in terms of rate of
inflation can be very useful This form is called relative or
dynamic form of PPP.
 Relative Version of PPP
• S*($/£)= (1+P*us/1+P*uk) -1
• S*($/£)=PERCENTAGE CHANGE IN THE
SPOT EXCHANGE OVER A YEAR .
• Alternatively
• S*($/£)=P*us-P*uk/ 1+ P*uk
• If the US EXPERIENCES INFLATION OF
5 PERCENT AND BRITAIN 10
PERCENT, THEN THE DOLLAR PRICE
OF POUND SHOULD FALL . THAT IS
THE POUND SHOUL DEPRECIATE AT A
REAT OF 4.5 PERCENT . If the reverse
conditions hold , POUND APPRECIATES
IN THE VALUE AGAINST THE DOLLAR
BY 4.8 PERCENT.
• Both values are closed to 5 percent
obtained taking an approximation

• S*($/£)=P*us-P*uk
• This equation is good when inflation is low
. Otherwise it will give a poor
approximation
 Criticism
1.Constraints on the movements oc
commodities
2. Price index construction
3. Effect of the statistical method employed
 Interest Rate Parity theory
• According to this theory the cost of money
( the cost of borrowing money or rateof
return on financial investment ) when
adjusted for the cost of covering foreign
exchange risk , is equal across different
countries .