EXCHANGE RATE REGIMES

MINT PARITY
• When the currencies of two countries are on a metallic
standard (gold or silver), the rate of exchange between them is
determined on the basis of parity of mint ratios between the
currencies of the two countries. Thus, the theory explaining
the determination of exchange rate between countries which
are on the same metallic standard (say, gold coin standard) is
known as the Mint Parity Theory of foreign exchange rate.

• By mint parity is meant that the exchange rate is determined

on a weight-to-weight basis of the two currencies, allowance
being made for the parity of the metallic content of the two
currencies. Thus, the value of each coin (gold or silver) will
depend upon the amount of metal (gold or silver) contained in
the coin and it will freely circulate between the countries.
• Under the system of gold standards, for instance, the rate of
foreign exchange is determined in terms of the gold content
of the two given currency units. This is referred to as mint
parity. Thus, if currency A contains 10 grams of gold and В
contains 5 grams of gold, then rate of exchange is: 1A = 2B.

• In practice also, before World War I, England and America

were simultaneously on a full-fledged gold standard. While
gold sovereign (Pound) contained 113.0016 grains of gold the
gold dollar contained 23.2200 grains of gold of standard
purity.

• Since the mint parity is the reciprocity of the gold content

ratio between the two currencies, the exchange rate
between the American dollar and the British Sovereign
(Pound) based on mint parity, was 113.0016/23.2200, i.e.,
4.8665. That means, the exchange rate £ 1 = 4.8665 can be
defined as the mint par exchange between the pound and
the dollar.
• Today, however, the method of determining currency value
in terms of gold content or mint parity is obsolete for the
obvious reasons that:
(i) None of the modern countries in the world is on gold or
metallic standard,
(ii) Free buying and selling of gold internationally is not
permitted, by various governments and as such it is not
possible to fix par value in terms of gold content or mint
parity, and
(iii) Most of the countries today are on paper standard or Fiat
currency system (Fiat money is government-issued
currency that is not backed by a physical commodity, such
as gold or silver) .
 PURCHASING POWER PARITY
• PPP was created after WWI. After the war, the Swedish
economist Gustav Cassel suggested multiplying each
currency's pre-war value by its inflation rate to get the new
parity. That formed the basis for today's PPP.

• Purchasing power parity is based on an economic theory

that states the prices of goods and services should equalize
between countries over time. International trade allows
people to shop around for the best price. Given enough
time, this comparison shopping allows everyone's
purchasing power to reach parity or equalization.
• PPP indicates that exchange rate between two countries
should equal to the ratio of similar goods and services in
both countries.

• For example, if one kg of Potato costs INR 18 in India and

similar quality of potato costs 50 cents in USA, then the PPP
exchange rate would be INR 36 per USD. This is the
absolute version of theory of purchasing power of parity. In
other words, the exchange rate between two currencies
can be represented as
• Though lots of empirical research have been undertaken to
test whether PP holds or not, The Big Mac Index calculated
by the Economist is the most well known test on PPP.

• The “Big Mac index” published by Economist tries to find

out what should have been the PPP governed exchange
rate. As McDonald burgers offered in many countries are
standardized, PPP governed exchange rate is found out by
comparing the prices of burgers between two countries
and comparing the exchange calculated to the actual
exchange rate.
• For example, Price of a Big Mac is USD3.57 in the USA and
price of a Big Mac is INR 99 in India. This means that the
implied purchasing power parity is INR 27.73 per USD.
However the actual exchange rate is INR 48 per USD. This
indicates that INR is undervalued valued by [(27.73-
48)/48]*100= -42.29%. It indicates that INR should appreciate
in near future.

• Let us take another example. Suppose a Big Mac costs about

$2.99 in in USA and costs €2.5 in UK. The prevailing exchange
rate is GBPUSD 1.5371(USD 1.5371 per GBP). As per the Big
Mac exchange rate, the GBPUSD rate should be USD 0.8361
per GBP. As per the actual exchange rate, USD is undervalued
by 45.6%. USD should appreciate by 45.6%.

• PPP calculated by comparing price of one good across in

different currencies is known as Absolute PPP
• Another form of less stringent PPP stresses on comparing price
index of basket of goods in both countries rather than
comparing any one good/service.

• It indicates that if a country is experiencing higher inflation

(higher price level) compared to another country, its currency
will depreciate relative to other currency.

• In other words, the spot rate between two countries can be

determined by comparing the price index of a basket of similar
goods and services. It is very important to understand at this
point is that price index should comprise of “similar” goods &
services” consumed by residents of both countries.
• On a given date, suppose a basket of goods &
services costs INR 5000 and a similar basket of
goods & services cots USD300, the spot
exchange rate on that date should be
 INTEREST RATE PARITY
• Interest rate parity is one of the most important
fundamental economic relation relating differential interest
rate and forward exchange rate between a pair of currency.

• The parity condition requires that the spot price and the
forward or futures price of a currency pair would be
governed by interest rate differentials between the two
currencies.

• In other words, the interest rates paid on two currencies

should be equal to the differences between the spot and
forward rates.
• For example, Let us assume that interest rate
prevailing in India is 8% per year while in USA
it is 3% per year. Suppose the spot rate INR
47/USD. The interest parity says, that one year
forward rate would be governed by the
interest rate differential. This indicates as on
today, the 1 year forward rate will be:
• Intuitively, it is a very simple concept. Suppose spot
rate prevailing on today is INR47/USD. A person
intends to invest INR 47 for year at 8% interest in India.
Otherwise, he can convert INR 47 to 1 USD and invests
in USA at 3% per annum and simultaneously buys a
forward cover to sell 1.03 USD after a year. In both
options, the investor should have the same return.

• Option 1: investing in INR at 8% would result in INR

50.76.
• Option 2: Investing in USD would result in USD 1.03.

• The forward exchange rate must be such that, if the

investors sell USD 1.03, he must earn INR 50.76. Hence
the 1-forward rate prevailing in the spot date would be
INR49.28/USD.
What if the actual forward rate differs
from the interest rate parity???
• Forward rate governed by Interest Rate Parity:
INR49.28/USD.
• Actual forward rate prevailing: INR 50.25/USD.

• INR 47 investment in India at a rate of 8% results in INR

50.76. However, if investor converts it to USD and
invests in US market, the investor receives USD1.03.
The investor sells in forward market at a rate of
Rs.50.25, he receives INR 51.75. Hence, everybody
would like to borrow money in Indian market, sell INR
and buy USD, invest in USD and simultaneously enter
into a contract to sell USD forward
• With many investors trying to benefit from the
arbitrage, borrowing in INR would increase.
Hence interest rate prevailing in India would
increase. Simultaneously, interest in USA
would go down and many arbitrageurs would
be willing to lend USD. Simultaneously
investors in USA would also be entering into
contract to sell USD forward thus reducing the
forward rate. This would result in adjustment
in spot rate, interest rates prevailing in both
countries as well as the forward rate.
Fixed, Floating and Managed Exchange
Rate Regimes
• The exchange rate regime is the way a country manages its currency
in respect to foreign currencies and the foreign exchange market.

• Exchange rate regime is the method that is employed by

governments in order to administer their respective currencies in
the context of the other major currencies of the world.

• The domestic foreign exchange market and the exchange rate

regime are intrinsically linked to monetary policies.

• Fixed and Floating are the two extreme exchange rate regimes and
in between these two many combinations of exchange rate
regimes can be possible which may be partly fixed and partly
floating.
Fixed Exchange Rate Regime